A quick guide to the benefits and costs of invoice factoring
Invoice factoring is not a suitable financial solution for every business. Suppose your business raises only a few invoices and customers settle their accounts within 15 days, for example. In that case, the benefits you would gain from factoring invoices would be minimal. And, of course, if a business is a cash-only operation, you will have no accounts receivable accounts (AR) to finance.
The above scenarios are relatively clear-cut. But for most businesses, the cost-benefit analysis of factoring is somewhat more complicated. Even so, it is advisable to quantify and weigh the costs and benefits before you enter any financial agreement.
The value of savings to be gained from factoring will vary by company. And the fees and charges levied by various factoring companies will differ, too. Even so, the costs and benefits can be quantified and compared. This article offers an explanation of the benefits and costs of factoring to help complete your cost-benefit analysis.
Benefits of Sales Invoice Factoring
Factoring reduces the time it takes to realize cash from accounts receivable. And the extra money realized can be put to many uses. So, a cost-benefit analysis of factoring is not restricted to a straightforward comparison of interest rates. Other advantages must be quantified, too. Here is a list of the benefits to be accounted for in a sales invoice factoring cost-benefit analysis.
Reduced Need for Other Forms of Financing
When you first enter into a factoring agreement, you will receive an initial advance against your current accounts receivable. That advance, ranging from 85-95% of the invoice value, will provide an instant increase in working capital. And that float of cash is topped up as new customer invoices are issued.
Factoring can reduce or eliminate the need for other financing solutions, such as overdraft facilitates or bank loans. So, the first item on the plus side of your cost-benefit analysis is the interest saved on alternative forms of working capital finance.
Bad Debt Reduction or Elimination
Unfortunately, bad debts are a fact of life and most small businesses incur bad debts amounting to an average of 2.7% of revenue. But, depending on the type of agreement, accounts receivable factoring can reduce or eliminates bad debts. So, this, too, needs to be included in the cost-benefit analysis.
If you sign up for a non-recourse factoring service, the factoring company will bear the risk of bad debts. So, in most scenarios, you will not need to repay advances made to you if invoices are not paid. However, there may be some situations in which the factoring company will not bear the cost. Even so, a non-recourse factoring arrangement will eliminate the cost of most bad debts.
In a recourse factoring arrangement, unpaid invoices will be charged back to you. However, if the agreement includes AR management, you can also expect your debts to fall. Bad debts are likely to reduce when you outsource AR management because the factoring company will credit-check new customers for you. And a factoring company will employ a professional team to carry out the task of collecting unpaid invoices.
Reduction in AR Administration Costs
When you outsource your accounts receivable to a factoring company, you will eliminate the AR administration costs. The factoring company will pay for credit checks, for example. You will no longer have the time-costs of chasing overdue invoices. And the costs of the supplies used for sending reminder letters and statements will also be eliminated.
How much you save on administration costs will depend on the volume of sales invoices. But, if you have a high monthly volume of sales invoices, the annual admin cost could be significant. And you may also benefit by reallocating employee time to more productive tasks.
Reduction in Cash Flow Management Time
When you factor sales invoices, you can be confident of receiving most of the cash from sales invoices within 24 hours. So, cash flow forecasting and cash management become much less challenging. As a result, you or your finance manager will spend less time juggling the cash flow forecast because of late-paying customers. And it will reduce the number of collection calls you get from vendors, further reducing administration costs.
The increased availability of cash will allow you to pay vendors faster. So, you will probably be able to negotiate better prices with vendors or take advantage of early settlement discounts. Having healthier liquidity might also improve your negotiating position with new vendors. And the improved liquidity will enhance your business credit score, making it less challenging to obtain other types of finance at favorable rates.
Fund Sales Growth
Customers typically might take 30-90 days to pay sales invoices. But, in the meantime, a growing business must fund the purchase or manufacturing of more products to meet demand. Wages and salaries will need to be paid in the month they are incurred. At the same time, vendors might be chasing for payment in 30 days. So, that can leave a significant funding gap which can impede growth.
Invoice factoring eliminates the wait for customers to pay their sales invoices. So, the working capital cycle is shortened and more cash is available to fund the next purchase or production costs required to meet the next batch of sales orders. And so, the company can fulfill customer orders faster, speed up sales growth, and increase gross profits.
The Cost of Invoice Factoring
Each factoring company will have its own fee structure. But the primary fee for factoring, sometimes known as the discounting rate, will be a percentage of the value of sales invoices financed.
The discounting rate, usually between 1% to 3%, might be a flat fee. Or the fee may vary depending on how long an invoice remains unpaid. For example, factoring fees might be 1-2% for the first 30 days, followed by 0.5% for every ten days outstanding after that.
Factoring rates are determined based on several things, including the volume of invoices, the average value of invoices, and customers’ creditworthiness. The industry sector you operate in may also affect the factoring rate, as will the average number of days your customers usually take to pay.
Initial advance percentages may also vary with the factoring provider. And the rate advanced against a sales invoice will affect the fees charged. So, you will need to include the advance percentage in your estimated factoring cost calculation.
However, some factoring companies build most or all their costs into their factoring rate. But others charge separately for some additional services and expenses. So, it is crucial to include all the various charges when preparing a cost-benefit analysis and comparing factoring quotes.
Additional costs of factoring charges might include credit checking fees, invoice handling charges, wire fees, and chargeback fees. Some agreements may also stipulate a minimum monthly fee.
The Bottom Line
To sum up, invoice factoring can benefit any company that issues a reasonable volume of sales invoices. But to determine the total value of those benefits, all the above must be included.
In most cases, you will find that the value of the benefits will more than cover the cost of invoice factoring. However, factoring may not be the solution for every business. So, it would be advisable to investigate the costs and benefits before signing a factoring agreement.
Your Questions Answered Quickly
Whether your business is thriving and you can’t keep up, or you are waiting on clients to pay, Universal Funding can help your growing company. Call us at 800.405.6035 or complete our rate form today to learn more about invoice factoring and how it can improve your company’s cash flow.
About Universal Funding
Universal Funding is a nationwide invoice factoring solutions leader, supporting growth-focused businesses with scalable factoring solutions. With its invoice factoring, payroll funding, and purchase order financing services, Universal Funding provides clients with the working capital needed to grow and support their businesses without taking on new debt. Ranked as one of the nation’s top invoice factoring companies, Universal Funding provides cash flow financing for businesses all across the United States.