Factoring or the sale of accounts receivable as a form of financing
FINANCE
Factoring, or accounts receivable sales, is the process of a factoring company purchasing a business's commercial invoices. Funds are received quickly, usually within 24 hours, and the factoring company then collects from the clients. It is an alternative for small businesses to get immediate fundsnot having to wait until accounts receivable are due.
Factoring or the sale of accounts receivable as a form of financing
Factoring, or accounts receivable sales, is the process of a factoring company purchasing a business's commercial invoices. Funds are received quickly, usually within 24 hours, and the factoring company then collects from the clients.
The main reason companies turn to this solution is to obtain immediate funds, rather than waiting for invoice payment deadlines, which can be up to 90 days in some cases.
The amount the company can obtain through this means will depend on its specific circumstances.
Some companies may sell all of their invoices, while others may only sell invoices with a longer collection period.
Through factoring, companies can improve their cash flow to meet urgent expenses and even generate new revenue.
The Factoring Process
The steps in the Factoring process are as follows:
► The company invoices a client
► Send the invoice to the Factoring company
► The company receives an advance from the Factoring company, usually within the next 24 hours
► The Factoring company collects the invoice from the client
► The Factoring company pays the company the remaining amount of the invoice (total amount less the advance), while deducting its commission.
Additional advantages of Factoring
In addition to improving cash flow, factoring has some additional advantages:
► Customer collection support
► Based on the quality of the customer's credit and not the company's credit
► Provides funds when the company needs them most
► No debt is incurred
► It is scalable, since the amount of financing grows as the company grows
Types of Factoring
There are two main types of factoring related to ultimate liability in the event of customer default: recourse and non-recourse.
Factoring with recourse: This means that if the factoring company cannot collect the invoice from the end customer, the company must take charge of the invoice and return the funds.
In the case of the Factoring without recourse: The factoring company will assume the risk of the end customer not paying the invoice. Of course, this option is more expensive.
Many factoring companies offer both options. The terms vary, so it's wise to understand them thoroughly before deciding.
How much does Factoring cost?
Factoring companies generally use two different models to calculate their commissions:
► A single rate that includes all commissions
► Two separate rates, one applied to invoices and the other applied to the overall account
It's very important to understand how these rates are applied. For example, a flat rate typically ends up costing significantly more in the long run.
Another important factor that affects the final cost is whether the fee is calculated on the advance payment or the total invoice amount. For example, if the rate is 1%, the invoice is for $100, and the advance is 80%. Applying the rate to the invoice amount would result in a cost of $1. If it's applied to the advance payment, the cost would be $0.80.
How rates are calculated
There are several models for calculating rates. The most popular are:
► A single discount rate: for example: 1% every 30 days
► A discount plus a margin; for example: 0.5% every 30 days plus interest of PRIME+2%
The value of the rate will depend on several factors:
► The calculation model used by the Factoring company
► The risk level of the company and its customers
► The amount of invoices that are planned to be delivered monthly
Examples
Single rate on the total amount of the invoice
In this model, which is used by some factoring companies, commissions are calculated by applying a single rate to the total invoice amount, rather than to the advance payment.
Let us assume the following conditions:
► 2% discount rate for the first 30 days and an additional 1% rate for each additional 30 days
► A $100 invoice that is paid within 60 days
The commissions to be paid in this case would be:
First 30 days: $100 x 2% = $2.00
Second 30 days: $100 x 1% = $1.00
Total Factoring Cost: $3.00
Discount rate plus margin
Most factoring companies use this combination of a fixed fee plus an interest rate based on the invoice amount.
The interest rate typically used as the basis for the calculation is the PRIME rate, a short-term interest rate commonly used in the U.S. banking system. All U.S. lending institutions (traditional banks, credit unions, savings and loans, etc.) use the U.S. PRIME rate as an index or base rate to price various short- and intermediate-term credit products.
The current PRIME rate can be consulted on the page FedPrimeRate.com
Let us assume the following conditions:
► Annual rate: PRIME + 2%
► Plus a 1% discount rate every 30 days
► A $100 invoice that is paid within 60 days
► 80% advance on invoice
PRIME + margin = 7.5% + 2% = 9.5% per year
Daily rate = 9.5% / 365 = 0.026%
This rate applies to the advance payment and not the total invoice amount, meaning it is applied to an amount of $80.
The commission amount for the PRIME rate + 2% would be: $80 x 0.026% x 60 days = $1,248
Second, the fixed rate commission: 1% every 30 days for 60 days would be 2%
Fixed rate commission for 60 days: $100 x 2% = $2.00
The total commission would be $1.25 + $2.00 = $3,248
The above are the most common factoring options, but they are not the only ones. Before selecting a factoring company, you should carefully read and understand the proposal, review the documents, and consider other important variables.
Generally, commissions will fluctuate between 1% and 4%.
Aspects that affect the company's risk level .Regardless of the method used for the calculation, the rate will depend on the level of risk that the company represents.
Several factors affect the level of the discount rate. These are the most important:
► The company's average collection time
► Concentration of accounts receivable
► The company's invoice volume
► The solvency of the company's clients
Average collection time
Average collection time is the average number of days it takes a company to collect its outstanding invoices. As a general rule, the shorter the time required to collect an invoice, the lower the risk of non-payment and the lower the factoring rate.
The number can vary depending on the industry in which the company operates, but generally, an average collection time of 1.5 times the invoice terms is considered good.
Concentration of accounts receivable
As part of the analysis process, a factoring company will carefully consider the percentage of receivables each client represents. It will pay special attention to the concentration ratio to measure the company's risk in the event of non-payment.
The greater the concentration, the greater the risk, since if something were to happen to one of the most important clients, the business would suffer considerably. As a general rule, the more clients a company has, the better the accounts receivable are distributed among them, and the lower the concentration risk.
However, the concentration ratio is a relative factor. Only a thorough analysis of the accounts receivable can help the factoring company make a final decision.
Invoice volume
The volume of invoices the company plans to submit for factoring significantly affects the discount rate. Factoring companies incur various costs to establish and manage an account, many of which will be the same regardless of the volume of invoices submitted.
As a general rule, the more invoices you plan to deliver, the lower the fees you will have to pay.
Customer solvency
It is clear that the higher the creditworthiness of the customers, the lower the discount rate will be.
Summary
Factoring, or the purchase of accounts receivable, is an attractive form of financing for a business. It allows for quick funding based on the solvency of customers, not the company itself.
Factoring companies charge a commission based on the invoice amount, which depends on several factors, such as: average collection days, concentration of the accounts receivable portfolio, invoice volume, and the creditworthiness of individual clients.
Commissions will depend on the analysis of these factors, in addition to a detailed review of the company and its client portfolio.