Factoring can provide quick financing for your business, but is the speed worth the cost? You’ll learn how to calculate the true cost of this alternative financing option, and how to determine if it’s the right for your business.
What is factoring?
Factoring is one way for a small business owner to obtain business working capital financing. You obtain funds by “selling” your accounts receivables “A/R” or customer purchase orders “P.O.s” to a financing company (called a “Factor”). The Factor pays you an “advance” on the face value amount of the A/R or P.O. The Factor then handles the collection of your A/R or P.O., for which it charges a fee. When the receivables are collected, the Factor will first use the money to pay off your advance and its fee. The remaining money will go back to you.
Why use factoring?
Factoring is sometimes used by small business owners as a short term business loan. Businesses with receivables in need of working capital that do not yet qualify for traditional bank lines of credit might turn to factoring.
Often when a small company is growing, it does not produce enough internal cash flow to pay its bills while waiting for its customers to pay their receivables. A Factor is more willing to lend to businesses with weak credit since they are looking to get paid back by your customer, not you. No additional collateral or personal guarantees are needed. Also, the time to obtain financing is usually quick.
The downside to factoring is the relatively high cost you pay for these services.
How do I calculate the true cost of factoring?
Because factor financing is short term (usually 30-45 days), you will not see an annualized percentage rate (“APR”) published. However, you should know the true cost of your periodic factoring, which reflects the money you are being charged by the Factor relative to the money that was advanced to you.
To calculate the true cost of factoring, you need to have the following information:
Advance rate: The percentage (%) of the face value amount of accounts receivable the Factor will advance to you.
Example: $100,000 (A/R) x 80% advance rate = $80,000 (Advance)
Discount rate (or factoring fee): The percentage (%) of the face value amount of accounts receivable the Factor will charge you for processing these receivables for an agreed upon term.
Example: $100,000 (A/R) x 3% discount rate (for 30 days) = $3,000 (Discount Fee).
Term: The number of days your advance remains outstanding. The discount fee increases for each day your receivable remains outstanding past the agreed upon term.
Using this information, you can calculate the true cost of factoring. Your annual interest rate appears to be 36% based on the discount fee of 3% for 30 days. However, when you consider that you only received $80,000 not $100,000, your APR is actually 45% (and even higher if your receivables take longer than 30 days to pay). Make sure to use this APR to compare factoring to other financing options that may be available to you.
What are the alternatives to factoring?
Small business owners with receivables in need of working capital who do not qualify for traditional bank lines of credit may be eligible for financing from community lenders, such as Community Development Financial Institutions (“CDFIs”). CDFIs are primarily non-profit organizations that have access to lower cost community and economic development loan funds to provide smaller dollar amount loans to business owners who do not meet conventional banking criteria.
Many CDFIs are also “Community Advantage” lenders that offer SBA loans up to $250,000. The U.S. SBA is the largest funding source for small businesses in the United States. The APR on CDFI and SBA financing is significantly lower than it is for factor financing!
If you are a small business owner in need of business working capital, avoid the high cost associated with financing products such as factoring, merchant cash advance, and typical online loans by exploring alternative, lower-cost financing options available through your local CDFI.