Factoring Versus Loans

Understanding what is the difference between Factoring and traditional Bank Loan.

   Typically, the first thought of a business owner seeking to improve cash flow, is to go to a bank.  Historically, we know that accounts receivable funding is very rarely thought of when attempting to overcome a working capital challenge.  We can certainly say that most business owners have been programmed to seek bank-related financial solutions for their funding needs.  When presented with an alternative such as factoring, it is quite understandable for the business owner to equate all of the terms and conditions inherent in factoring with the familiar “bank products.”

   The first of these misunderstandings concerns the amount of funds that the funding source will provide.  Very often, the business seeking working capital will look for a specific amount of money commonly referred to as its credit line or credit limit.  Traditional funding strategies dictate a limit on funds available based on the assets being pledged as collateral.  It is, therefore, quite common for a prospective factoring client to ask, “What is my line with your company?”

The Ability To Deliver A Product

   Unlimited availability of funds is very uncommon in the finance industry and sometimes cannot be grasped by a potential client.  In factoring, client's “credit facility” is based on his ability to deliver product (or services) and generate an invoice reflecting completion of delivery or service.  What we have is elasticity of funds, an unlimited line of funds that grows with the business and provides true cash flow as opposed to cash infusion.

   How often is the factor asked, “What interest rate do you charge?”  Once again, we see a traditional concept (interest rate) trying to fit a non-traditional funding strategy (factoring).  Businesses have been offered interest-related products for so long that they cannot understand that they can get funding without being charged interest.  We describe factoring as the sale of an asset (accounts receivable) at a discount. Let's look at the following example.  You go into an auto dealership to buy a new car.  The sticker price is $62,000.  You persuade the dealer to sell you the car for $60,000.  Did you lend the dealer, any money?  Of course not.  You bought the asset at a discount.

   It works the same way when a factor buys your invoice.  You can say that a 3 percent discount fee equals to 36 percent interest per year.

   The $2,000 discount in the discounted car example is equated to an approximate 3 percent discount on the car, the same discount the funding source quoted on factoring.  But did the dealer incur a 36 percent expense (interest rate) on that transaction?  Not at all, he discounted the car by 3 percent.  However, if the buyer of the car were to collect $2,000 every month after the purchase of the car, the dealer will have the equivalent of a 36 percent interest charge on the initial $60,000 he received on this transaction.  If we bought a new car every month at a $2,000 discount, the dealer would be giving $24,000 in discounts but not on one purchase of $60,000.  It would be on 12 purchases of $60,000 or $720,000 (the same 3 percent discount).

We Cannot Annualize the Factoring Discount Fee 

   In essence, one cannot “annualize” the discount fee without annualizing the amount of funds applicable to the fee.  To illustrate further, on a $100,000 factoring transaction, if the factor gets a $3,000 fee for 30 days the normal misunderstanding would equate that to a 36 percent interest rate by annualizing the fee (fee X 12).  The concept that is missing is that if the fee is annualized, the total funding for the year must be taken into consideration as well. $36,000 in fees requires 1.2M in funding ($100,000 X 12), the same 3 percent discount we started with.

   Here is a very common objection.  “My bank is going to charge me prime plus 4 percent, which is about 8 percent per year on a $1,000,000 loan.  Can you compete?”  But for the same $80,000 per year expense you could have had $2,000,000 for the year in funds (assuming that your debtors pay every 40 days).  More importantly, the 8 percent interest rate on the loan is just one component of the overall fees applicable to that loan.  Other fees and expenses will bring up the APR to well over 20 percent.

   We are here to help you.  Please call us so that we can answer all your questions and concerns.

 

Also see Factoring FAQ