As customers take longer and longer to pay invoices, more and more businesses are looking for alternative financing options like invoice factoring. After all, these late customer payments have a cascading effect on business credit. Late customer payments mean companies are late collecting on receivables and paying their own vendors and creditors. In response, banks and credit unions raise interest rates and make it more difficult to secure affordable business credit . However, can factoring help alleviate the pressures companies face from late customer payments?
Understanding Asset-Based Financing
Invoice factoring is like most asset-based lending options in that it works by using the company’s existing assets to secure working capital. It is a financing method that has grown increasingly popular amongst today's businesses. It provides companies with a solid alternative to the constant struggle of late payments and rising interest rates on bank loan financing.
Factoring isn’t a loan, doesn’t require a review of the company’s financial statements and therefore won’t appear as a liability on the company’s balance sheet. However, the question often becomes, can factoring help protect the company’s profit? It can, provided the company understands its costs of capital and how it plays a role in its gross profit. So what is a company’s cost of capital and what are the steps to determining if factoring is a viable financing method?
Step 1: Determine Average Number of Days on Receivables by Customer Account
Companies have the option to factor individual customer accounts and their invoices. As such, it only makes sense to determine the cost of capital by individual customer account. This means to track the customer’s average number of days paid on receivables. Start first with capturing the customer’s average number of days on receivables.
Step 2: Focus on Worst Offenders
Identify those customer accounts that exceed your company’s standard net-30 day terms by an amount you deem to be too long. The idea is to dial into those customers who average 60 or more days paying invoices and reduce the financing costs to support those invoices. If you've never done this before, it's a sure bet you'll be surprised to see just how much the costs are to finance your company's receivables.
Take the average number of days in receivables and determine the company’s cost of capital. What does this include? Well, a company's cost of capital is basically its daily cost of money. The cost of capital is the company’s yearly interest rates charged on bank loans and credit lines. It is the company's financing costs to support its inventory and its customer's unpaid invoices. This yearly interest rate is converted into a daily interest rate and then multiplied by the COGS (cost of goods sold) in order to determine the company's financing costs.
Step 4: Compare Standard Bank Loan Financing Costs Versus Factoring Costs
Once you’ve determined your individual customer’s cost of capital, the next step is to compare the bank loan financing costs relative to the costs of factoring. Now, it's more than likely that factoring will be a more expensive option, but it's important to understand the inherent benefits of the service.
First, you company isn't financing its product's COGS (cost of goods sold) as you are with bank financing. Instead, you're paying a financing cost against the advance you receive from the factoring company and this amount is always higher than your COGS.
Second, securing capital upfront allows your company to reduce operational costs across the board. For instance, you can reduce your inventory costs, per-unit freight costs on incoming parts and you can secure prompt payment discounts for early payment with vendors and creditors.
Third, as mentioned earlier, factoring isn't a loan and won't affect your balance sheet. Fourth, your credit history plays no role in advancing your company credit. Instead, the decision is made on the account debtor's credit rating - which would be your customer's credit rating. In essence, it’s a comparison of the company’s costs of waiting for customers to pay invoices (cost of capital/daily cost of money) relative to the costs to use factoring as a service.
The table and video above are taken from the post: Sample Receivable Factoring Excel Sheet: Effective Rates & Interest Rates
When looking at invoice factoring, be sure to measure your company’s financing costs to support certain receivables. When properly managed, factoring can be a reasonable alternative to standard bank loan financing. What’s needed is an honest assessment of the company’s financing costs and its impact on gross profit versus the costs of the fees that factoring companies charge.
If the costs of factoring are less than your company’s costs of supporting receivables, then it’s worth looking into factoring. However, also remember that factoring is immediate and a guarantee of some form of payment. This helps to improve cash flow and alleviate the concerns of late customer payments.
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