Invoice factoring is a commercial financing method whereby accounts receivables are leveraged to access working capital to grow a business. In fact, an invoice is a loan made by the business to their customer. The work has been performed or the product shipped and the business is waiting for the customer to pay the bill.
What a factoring company does, is purchase that loan or invoice, and pay the business today and thereby shortening the time between jobs being finished and payments made. This allows the business to complete more jobs during the year and also consider larger jobs allowing that they will get paid upon completion.
So as the factor provides working capital using receivables as a borrowing base, the cost of doing this is sometimes misconstrued as simple annual interest. The perception is not based on the actual transaction and how it is structured. If the business was simply borrowing money over a period of time and then repaid the loan with interest - this would be a conventional loan that would be implemented by a banking institution. A bank would have normal guidelines that a business would need to have covered in order to qualify for a conventional loan.
Utilizing factoring for working capital is viewed as an alternative to conventional lending. For a variety of reasons a bank might not be able to qualify a business for a loan. Or more frequently, the loan a bank might offer may help today but is not adequate tomorrow or next month. So the business might turn to factoring as another option to consider for their cash flow needs.
The main difference between the two is, a bank when underwriting the loan feels that within a 12 month period not much significantly will change financially with the business other than the potential to have increased growth and a stronger balance sheet - hence the long leash. But again for a variety of reasons, the bank cannot offer a loan or the loan amount will not satisfy the need - and so factoring invoices is an option.
When a factoring company provides funding on a 30 day invoice, the factor will know within a short period of time (30 - 60 days) whether there will be some sort of issue regarding payment of the invoice - in this case, a short leash. So the difference between the two is how they are structured for repayment. On a long leash (bank,) a computer oversees that monthly loan payments are made in a timely fashion. On a short leash (factoring,) the factor must have hands on verification processes in place to oversee the invoice from the time the job is completed until the invoice has been paid in full.
During this time span, plenty can go wrong. But with a short leash a factor can be on top of a problem quickly, while with a bank, a problem can spin out of control for months and months without the bank being aware of the situation until much later - which in many cases doesn't help the business in the long run.
All of this preamble is to set up the point of this article which is, what is the cost of factoring. The cost of factoring is not the annualized interest rate on a loan amount, or advance on an invoice. The business might make this calculation to internally track the cost of funds when considering a project, but it does not reflect what the factor is providing to the business.
The cost of factoring is a service charge for providing the working capital. Built within this service charge are; setting up the factoring relationship, filing the proper documents with various agencies, underwriting each invoice transaction, including determining the creditworthiness of the customer, notifying the customer that the proceeds of the invoice have been assigned to the factor, verifying with the customer that the work has been completed and accepted without set offs or credits, making the advance on the invoice (wiring the money,) tracking the payment and helping with the collection on late payments, once the payment is made to the factor, calculating the fee based on days outstanding and issuing the reserve payment to the business to settle this one transaction.
Multiply this by each invoice from every business client including when problems arise like the customer orders blue but the business sent red or the customer can't find a copy of the invoice 40 days later or the customer sent the payment to the business rather than the factor. All of the activities in this and the previous paragraph require staff to process. This is the main reason banks don't do factoring - they are not set up to handle the daily work load for each transaction.
Bear in mind, a majority of the factoring companies borrow their capital - from a bank. So essentially the business is leveraging the factors' ability to borrow, and the factor is using its processes to oversee short term transactions. And that in a nutshell describes small business factoring.
Company: Creative Capital Associates Factoring Co. Aug 19, 2015