How far will you go to stay in business? If a company’s finances are not solid enough to receive lending from a bank, factoring companies are promoted as a quick way for businesses to raise cash and live happy ever after. However, everything comes with a price. With this hope comes an exorbitant amount of fees and oppressive interest. Is a factoring company a white knight or a knockout punch for a struggling business? Let’s look at the facts:
How Factoring Works: A factoring company buys the accounts receivables from its clients (money owed to the client from their customers). The factoring company gives their client an advance of 70 to 90 percent of the total expected payments they will collect on the company’s behalf. In exchange, the factoring company will receive a percentage (points) of the total balance factored as a fee (anywhere from 0.5 percent-3.0 percent). This is in addition to thousands of dollars of fees for setting up, renewing, and auditing the factoring company’s clients.
The majority of the fees are earned by the factoring company on the points it collects. Seem reasonable? The following illustration shows how much that can actually cost a company.
• Company factors $100,000 in accounts receivables every 30 days, and it takes the factoring company 30 days to collect the accounts receivables.
• The factoring company purchases and collects the $100,000 accounts receivable, but only actually lends $85,000 (since the advance rate is 85 percent). Under this scenario, the company is essentially borrowing $85,000 for 12 months.
• The factoring fee is two points of the purchased accounts receivable every 30 days
• $15,000 of additional fees paid throughout the year (setup, renewal, audits, etc.)
Accounts receivables sold to factoring company: $100,000
Cash advanced to the client: $85,000
Fee of 2 points or $2,000 per advance, 12 advances: $24,000
Additional fees: $15,000
Cost of borrowing $85,000 for one year, $24,000 of points + $15,000 additional fees $39,000
$39,000 fees / $85,000 borrowed funds = 46 percent interest.
After you add up all of the fees and points, the actual costs may far exceed the allowable interest rates dictated by usury laws (which limit the amount of interest which can be charged on loans.) But because factors claim to be buying assets not strictly giving loans, they do not fall under such usury law regulations.
I don’t know what you think, but I am pretty sure a struggling company will have difficulty paying back a loan with 46 percent interest. Does it ever make sense? Sure, if a company has no other alternative and your ROI on the loan exceeds 46 percent. Otherwise, a factoring company is simply pushing a drowning company further underwater. In the interest of presenting a well-balanced discussion, the following article has a different, inaccurate take on the “are factors loan sharks” question.
Are Factors Loan Sharks?
Invoice Factoring and Asset Based Lending are more expensive than bank financing and, usually, a lot more expensive. Because it is priced so attractively, bank lending is every business’ first choice. But when the tough credit standards that allow bank credit to be attractively priced keep borrowers from obtaining adequate financing for their needs, Factoring or Asset Based Lending may be the next choice. The specialty finance industry is largely unregulated and some borrowers have had bad experiences with the wrong providers but there are many responsible providers in the market that can be very helpful to a business that cannot obtain all the conventional bank financing it needs.
Why is it so much more expensive?
It helps to understand why Factors and Asset Based Lenders charge more. It is not because they are greedy, remorseless “Loan Sharks” that feel they are entitled to huge profits. Well-run factoring companies or asset based lenders do not make any more money than well-run companies in countless other industries. The free market and open competition see to that. In fact, factors and asset based lenders that do not run their business well — just as with businesses in other industries — do not last very long. Many fail.
Bank Cost and Pricing
Banks, in their conventional lending products, offer very low cost financing to their customers. There are some very important reasons for this.
• Banks borrow at extremely low cost.
• Banks are permitted to take deposits from businesses and the general public. All of us who have looked at a savings deposit statement realize that our banks pay us very, very little for the use of that money.
• Financially strong banks can borrow from the investing community in the Commercial Paper markets. These are short-term, institutionally traded instruments that are very low cost but are only available to large, highly rated businesses. • Banks are supported by the Federal Reserve System. If they are ever short on cash to conduct business, banks can borrow at incredibly low-cost from the Federal Reserve.
• Banks keep limited staff for the amount of money they loan, which keeps overhead very low.
• Because banks take deposits from the public, they are required to insure those deposits to make them safe for depositors. To support that insurance that is essentially provided by the American taxpayer, banks must submit to significant regulation by our government. As a consequence, a high standard of credit quality is imposed upon the lending activity of banks.
• Bank lending is structured around intense initial credit review of a borrower. But once the loan is made, bank staff is usually not very actively involved with the borrower. The ongoing relationship may require little attention for years.
Factoring & Asset Based Lending Cost & Pricing
The higher pricing of Invoice Factoring and Asset Based lending arises from their higher cost structure as compared to that of banks.
• Cost of Funds: The price Factors and ABLs pay for the money they borrow is a great deal higher than a bank’s borrowing costs.
• Equity: Equity, or investor capital, is the most expensive source of funds, usually more expensive than Factoring or Asset Based Lending. While banks use equity too, factoring companies and Asset Based Lenders typically need to use more equity as a percentage of their overall balance sheet because they are typically much smaller firms and their investors expect a higher return for the equity they invest.
• Leverage Borrowing: Factors and Asset Based Lenders work to lower their cost of funds by borrowing from banks. This is certainly less expensive money than their equity, but this means their least expensive source starts at the cost of bank financing.
Factors & Asset Based Lenders have higher operating cost structures.
• Being second choice to bank lending for most borrowers means factoring and asset based lending companies make loans the banks will not. Their processes and procedures are developed to manage this extra credit risk but this usually involves higher staffing ratios to add regular, day-to-day involvement with their borrowers. This adds meaningfully to operating costs.
• Inevitably — dealing in a market of higher credit risk — many factors and asset based lenders suffer losses for which they must provide reserves, adding to their cost structure.
So When Does It Make Sense to Use Factoring Companies and Asset Based Lenders?
When business owners are unable to qualify for adequate conventional bank financing because they are just starting up, rapidly growing, capital constrained, short on the fixed assets that banks prefer, or suffering a temporary financial adversity, they should take a few steps to determine if invoice factoring or asset based lending is a good choice for them.
• Shop: Find the best providers in terms of reliability, capability, experience with your type of business and price.
• Do Your Homework: Study competing proposals carefully and really understand exactly how much the financing would cost for the business you expect to do.
• Understand Your Own Business Model: Work with your finance and accounting professionals to really understand the profit margins in your business.
If the cost of Factoring or Asset Based Lending leaves enough of your profit margin left over to make it worth your time and effort, you do not have money of your own to put in, and you cannot get a conventional bank loan, it probably makes very good sense to consider Factoring or Asset Based Lending.
For more information on factoring, check out this informational website: http://www.factoring.net/