Today I decided to come up with a sample factoring excel sheet, one that compares the effective rates and administration fees of factoring versus the interest rates charged with bank financing on a product's "cost of goods sold". There is an important distinction to be made when looking at receivables factoring: It is an asset-based financing option that is essentially an advance on your receivable's total value.
This is different from bank financing where your company must cover interest rates on your product's COGS. We'll review why factoring itself has become more popular amongst companies in our current economy. We'll work through an example and then explain how the sample factoring excel sheet works. That sample factoring excel sheet is included at the bottom of this post.
Financing is Increasing Despite Low Interest Rates
Today's enterprises are seeing an increase in financing costs at a time when interest rates are at all-time lows. There are essentially three reasons for this. The first includes the issue of low customer demand. When customers don’t buy as frequently, then a company’s costs to finance its inventory increase. The second includes late invoice payments; today’s enterprises are in a cash crunch and maintaining a positive cash position often involves delaying payments. Both of these issues increase financing and both are commonplace in today’s economy.
However, while both of these aforementioned issues are concerns, they pale in comparison to the third reason financing is increasing; the high costs of customer bankruptcies. Customer bankruptcy substantially increases a company’s costs of financing as it often means a complete loss on the unpaid invoice. The video below provides some information on different asset-based lending options. The factoring options are explained afterward.
Understanding Factoring
Factoring is considered an asset-based financing option, one that allows your company to use the liquidity of current receivables (unpaid invoices) as collateral or credit. A financing company essentially purchases the right to collect your receivables. They’ll advance your enterprise capital based on the value of that unpaid invoice. Next, the financing company collects that invoice directly from your client. Once that invoice is paid, the financing company will credit you the difference between the original advance and the final payment. A transaction fee is then assessed for the financing services.
Factoring acts like a loan but will not be seen as one on your company’s balance sheet. In addition, your enterprise’s creditworthiness isn’t a concern for the financing company. Instead, the financing entity bases its decision to advance your enterprise capital based on your customer’s credit history. Understanding the benefits of factoring involves defining the costs of current financing relative to the costs of this asset-based solution. So, how is this done?
Step 1: Determine Current Financing
Take your existing interest rate on bank financing and divide it by 365 days in a year. You have just determined the daily interest rate you must cover every day you wait for your customer to pay their invoice. Next, take that daily interest rate and multiply it by your product’s “costs of goods sold” (COGS). This amount is your daily cost of borrowing money or otherwise termed as your daily cost of capital to finance this receivable. Finally, take this aforementioned amount and multiply it by the number of days it takes your customer to pay their invoice or termed differently, the number of days it takes your company to collect on the receivable. You now have a total cost to finance this particular receivable.
The following three blocks define an example based on a 6% yearly interest rate, COGS of $10,000.00, and a receivable that took 45 days to collect. We’ll continue to use this example in our next three steps and use this sample example in our sample excel spreadsheet.
Step 2: Decide on a Factoring Option
Continuing with our aforementioned example, the financing company would essentially advance your company anywhere from 80% to 90% of your receivable’s value. These values depend upon your willingness to assume some liability or risk for your customer’s final payment. Recourse factoring means your enterprise assumes responsibility for the receivable’s value. In this case, your advance is higher and your fees are lower.
Non-recourse factoring means your company assumes no responsibility for final payment. In this case, your advance is lower and your fees are higher. Non-recourse factoring often involves the financing company purchasing insurance to protect itself against the possibility of your customer going bankrupt. This is ultimately why the rates and fees are higher. In essence, the financing company must cover the risk of the account debtor (your customer) being unable to pay their invoice. Here are the two aforementioned factoring options.
Step 3: Define Total Factoring Charges
In most cases, factoring companies will provide the option of either a standard flat fee or a series of tiered factoring fees, each correlated to the average number of days it takes customers to pay their invoices. Your enterprise must understand all the fees involved in factoring; it’s not uncommon for companies to advertise one flat fee, without fully explaining their additional fees. In essence, there is often a separate administration fee for the factoring service, and separate fees for the right to borrow capital, fees that include the prime rate. The administration fee is typically charged against the receivable’s total value, while the interest rates are charged on the upfront advance.
Your company must define these costs and compare them to the yearly interest rates on existing financing. Here are the steps to follow: First, define the administration fee. Second, choose either the flat or tiered fee, based on your customer’s average number of days paying on invoices. Third, define the prime rate. This information is readily available on the internet and most financial websites. Fourth, define the total fee or “effective” rate. The following table defines the fees we’ll be using in our example.
Step 4: Compare Financing on Factoring vs. Bank Financing
Going back to our first step, we determined that the company’s current costs of financing its customer’s receivable was $73.97 based on the customer taking 45 days to pay their invoice, a product with $10,000.00 of COGS, and a 6% yearly interest rate. Continuing with our example, we’ll assume your company has chosen the non-recourse factoring option. As such, you’ll receive 80% of the invoice’s value as an advance. Now we need to define the total costs of using factoring. The following provides a summary of these costs.
In reviewing the above example, it’s important to remember that the financing costs on factoring are higher because your effective rate of 6% is charged on 80% of your receivable’s value. This means the 6% is applied to $12,000.00. This is different from standard financing where its 6% based on the product’s COGS of $10,000.00. In essence, there is a $2,000.00 delta that accounts for some of the difference in costs between factoring and bank financing. Also, your company may be able to lower the administration fee, thereby lowering its total factoring costs.
Sample Factoring Excel Sheet: Effective Rates on the Receivable's Value Versus Interest Rates on COGS
The sample excel sheet (above) is included at the bottom of the post. All you need to do is occupy the blue highlighted fields within the excel sheet. The other fields will do the calculation for you.
The first table: Enter your yearly interest rate, your product's COGS, and the number of days it took to collect on your receivable in the blue shaded areas.
The second table: Enter your receivable's total value, the advance on your receivable (whether recourse or non-recourse), the administration fee, the prime rate, the flat or tiered rate, and finally, the number of days it took to collect on the receivable.
While we used non-recourse factoring in this option, it’s important to note that the recourse factoring option would include a lower cost of capital. Most importantly, companies that use factoring can secure significant cost reductions with their vendors and creditors. They can use their upfront cash advance to secure favorable discounts on prompt payment and lower their costs to finance their day-to-day operations. When looking to define the value of factoring, be sure to understand all the fees involved and the benefits that come from having cash earlier than waiting for customers to pay their invoices. While factoring may be more expensive, it’s important to weigh its benefits against its costs. Most importantly, you must understand that the fees are applied against the advance and not your product’s COGS.
Here is the download: Download Sample-factoring-excel-sheet-comparing-effective-rates-interest-rates
Comments