Many business owners who have considered using invoice factoring as a way of generating working capital decide it's too expensive after they get the initial proposal.  Deciding not to move forward based solely on the factoring fee structure can be detrimental to the firm's market share, revenue cycle, and profits.

Although accounts receivable factoring has been around for centuries, many owners and financial executives aren't educated as to how it works.  When a factoring company receives an application and it appears the applicant is a good candidate for an invoice factoring relationship, they will issue an initial proposal called a Letter of Intent (LOI).  Subject to due diligence, the LOI specifies the proposed term of the contract, advance rate, and factoring fee stated as a percentage of the amount of invoices factored.

The last component of the LOI, the fee structure, is often a cause for concern for the potential factoring client.  The truth is that factoring is more expensive than traditional bank lines, although they are two different ptoducts.  We have outlined the differences in prior posts, emphasizing the additional services factoring companies provide to their clients.  But the cost of the financing is of primary importance to those who can't get a bank loan and are considering using factoring to finance their company's growth or survival.

When business owners geta proposal that states the factoring fee will be 3% per thirty days, many will shut the door immediately because the cost is too high.  We encourage decision makers to not reject factoring out of hand because of the cost.  Instead, a deeper analysis should be conducted to compare the fianncing cost to the opportunity cost of NOT moving forward with the arrangement.  If there is no appreciable difference between the two, then it may not be worth it to move forward.  But if factoring provides the funding needed to get a new customer's business or launch a new product line, the incremental profits may well indicate that the high financing costs are well worth it.

When analyzing the costs and benefits of invoice factoring, the decision-maker should first ask the question:  Could an immediate cash advance of 75% to 85% on my accounts receivable be utilized to grow or improve the business?   If so, how would it effect the bottom line?  The owner or CFO should then develop a spreadsheet that incorporates the projected revenues and/or cost savings associated with the advances as well as the projected financing costs.  For example, if the company has the opportunity to expand business to a customer as a result of the infusion of working capital, will the incremental profits exceed the cost of financing? 

Generating working capital through accounts receivable factoring can be a great way to jump-start a company's sales and profits.  But the profit margin must be adequate enough to cover the factoring fees charged.  Opportunity cost must be considered before making the ultimate decision to move forward or not.