Factoring accounts receivable can be a powerful way to fund growth, especially when bank loans and other sources are not readily available. With factoring, instead of waiting until the customer pays, the supplier can get immediate cash for invoices to fund new work and free up cash flow.

A supplier has entered into an agreement with the factor and has become a client to the factor. In this scenario we will factor invoices of $1,000 each month at a 5% discount rate and an 80% immediate payment of the invoice amount upon verification to the factor with 20% hold back until the invoice is paid by the customer of the client. In this example the customer will pay the invoice on day 30.

So under the terms of the factoring agreement, instead of waiting the 30 days, the client has sold the invoice, at the face amount of $1,000 to the factor. The factor pays the client $800 less $50 (the 5% discount) upon presentment and validation of the invoice. The remaining 20% is held back by the factor until the customer pays the invoice in full. The customer, or the debtor, pays the invoice on day 30. The factor then pays the remaining $200 to the client on day 30.

Leveraging the Freed Cash Flow

But this can get even more interesting. In our example the gross margin for the client is 40%. So for every $1,000 invoice this provides $400 cash flow. If the client decides not to factor, but to use their cash reserves to fund the customer those same 30 days, the opportunity cost is $400 as that $1,000 is not available for making and selling more products. With factoring the client is paid immediately $750 and only the $200 is held back as lost opportunity for those 30 days. So the opportunity cost is reduced from $400 to $200, or cut in half for that 30 day period.

Now we will leverage the freed up cash from the invoice. The $750 is now available to grow the business or meet some pressing need. In our scenario the client takes that $750 and uses it to buy supplies on 2% net 10 terms on the same day the factor funds the invoice. 2% of $750 is $15. So in the same month the $50 factor discount has saved the client an additional $15. So the net effective discount is $50 less $15, or $35. So the effective discount rate is not 5%, but 3.5%. So here, 5 is not 5, but 3.5, a 30% reduction.

If that same $750 can be converted into more sales in the same month, then an additional 40% gross margin on the $750 can be produced, or another $300 free cash flow. In this example, now that same factored invoice has produced an additional $15 and $300 cash flow or $315. This $315 offsets the $200 hold back by 158% or provides $115 free cash. This provides an equivalent cash flow of $400 plus $315, or $715 in the same month. Not bad for a 5% discount fee.

To accomplish that same net gross margin the client would either have to self-fund from his cash reserves $1750, or borrow $1750 from the bank to produce the same result from factoring the single $1000 invoice. If you have the money in the bank or in a line of credit you may not see this as an issue, but if you are cash flow constrained, then $1,000 factored can indeed match $1750 borrowed.

At a 6% annual interest rate, the borrowed $1750 has a net cost of $8.75 for that 30 day period, provided you pay it off in 30 days, else the cost is 6% of $1750 or $105 if you take a year to pay it off. Meanwhile the factored $1,000 that produced the benefits of $1750 still only cost the 5% discount, or $50.

Hopefully these examples demonstrate that the discount fee in factoring receivables is not the same as borrowing from a bank charging a standard interest rate. Just like the terms for a bank loan, the factoring terms depend upon the details of the participants and the situation.

The power of factoring is that the cash tied up waiting for the invoice to be paid can be released much quicker and used to fund further growth. This provides a key leverage when bank loans and other funds are not readily available.

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