When discussing invoice factoring with referral partners and prospective customers they frequently attempt to compare the cost of money through factoring to the cost of money through bank lending. This is a comparison that is not easy to make because the processes are so very different.
The following is a good way to explain the difference.
Comparison to Early Payment Discount
The most direct comparison for Invoice Factoring is the early payment discount offered by many companies to their customers. Traditional early payment terms are 2/10 Net 30. This means that the customer can take 2% off the face value of the invoice if they remit payment within 10 days of receipt of invoice. Otherwise they must pay the full price in 30 days.
This is precisely what Invoice Factoring does without offering the end customer the option to take the discount. There are advantages to taking this approach. One is that end customer does not get accustomed to the idea of a discount. Therefore, when a business no longer needs to factor its invoices that 2% goes directly to the bottom line.
Here’s another reason that factoring makes good sense. Some companies will insist on taking an offered 2% discount and pay in 30 days anyway. This completely destroys the purpose of offering the discount.
Factoring eliminates these two negative ramifications.
Comparison to Accepting Credit Card Payment
At its most basic level, invoice factoring is a means by which a business owner collects immediate payment from customers who either cannot or would rather not pay with cash. In the world of consumer-based businesses (and some commercial transactions) this is done by accepting payment by credit card. The Merchant Processing Fees charged for credit card payment range from 1.75% to 4% of transaction value. The type of card, bank, volume, etc., impact the actual transaction fee.
Square, for example, has a 2.75% fee for each transaction. [Square is the company that makes it possible to convert a cell phone, tablet or computer into a credit card processing device.]
Invoice Factoring is also a transaction based process. On a typical invoice factoring transaction, the service fee would be between 2% and 2.5% (depending on the specifics of the transaction). That’s less than taking payment by credit card.
Comparison to Bank Lending
The difference between factoring and bank lending is the difference between buying and renting. Bank lending is a rental fee. When you borrow from a bank (or access funds from a line of credit) you must pay those funds back in full, plus a little extra. That extra is the interest rate. This is similar to the fee you pay for renting a car. Once you’re done with the unit you must return it and pay for the privilege of usage. So it is with a bank loan. You have the privilege of using the bank’s money but must give it back when done and pay for the use.
In Invoice Factoring you have not borrowed money so you have nothing to pay back. You have sold an asset to the factoring company – an invoice that’s part of your company’s Accounts Receivable. (Typically there are multiple unpaid invoices in the A/R report at any one time.) That asset (the invoice) requires that your customer honor their obligation to pay for product and/or service. Thus the factoring company gets its money back when your customer honors that obligation.
Converting a discount rate (for example, the early payment discount noted above) to an interest rate is a unique calculation. It is not straight forward. Multiplying the discount rate by 12 months does not reflective the true cost of money because the “discount” is applied against revenue, not against a static borrowed amount. An interest rate, on the other hand, is applied against a borrowed amount.
For example, let’s assume $100,000 in invoices sold to the factoring company each month. Let’s further assume a discount rate of 2.5% on each invoice. [That, by the way, is on the high side.] In a year’s time $1,200,000 in future revenue would be sold to the factor. The cost of money would be $30,000 [2.5% of $100,000 = $2,500 x 12 = $30,000].
To calculate a comparative value for borrowed money you should take the interest rate of the lender’s offer and multiply it by $1,200,000. Here’s how that looks. The Lending Club (for example) recently advertised a rate “as low as” 5.9% per year interest. At 5.9%, on $1.2 million the cost of borrowed money would be $70,800 per year. If that revenue were factored the cost of money would be $30,000.
Understanding the difference between an interest rate and a discount rate requires looking at the financial transaction from a different point of view. “Cost of Money” is not a direct comparison. Using Cost of Money as the primary reason for a decision between the two financing models does not serve the business owner. The decision, as has been noted in other articles in this series, is better based on other considerations:
Can the business even qualify for bank lending?
Should the business refrain from adding debt load at this time?
Does borrowed money (or equity infusion) cause the owner to lose autonomy?
Financing, through either Invoice Factoring or Bank Lending, is a temporary situation. It is a support mechanism for business growth. As such, a business owner should assess his or her options based on the current business environment and choose the solution that will take them the farthest the fastest.