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The Business Lifeline: Leveraging Factoring for Cash Flow
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Factor Cost Factoring Accounts Receivable | 7 Park Avenue Financial
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Invest time in this article because it details factoring's financial implications, a cornerstone for savvy cash flow management
Factoring Unveiled: A Deep Dive into the Costs and Returns
The Growing Popularity of Accounts Receivable Financing in Canada
Canadian business owners and financial managers who are considering financing accounts receivable often ask us how they can calculate, or more so, understand the factor cost of factoring accounts receivable.
There are a whole bunch of factors (excuse the pun) that seem to be coming together to make the financing of accounts receivable a high-growth, popular, and accepted method of business financing in Canada.
The reality is that even just a few years ago most business owners did not even realize that they could sell their accounts receivable to a private non-bank firm, gaining valuable working capital, i.e. cash flow! in the process.
The Drive Towards Factoring
Business is being driven to this method of Canadian business financing out of a very basic need - meet payrolls, make fixed-term obligations, and purchase products and services.
And when your customers make you wait, 30, 60, and unfortunately 90 days for your funds all of a sudden factoring, also known as invoice discounting and receivable financing becomes very popular. Not hard to understand.
The Need for Understanding Accounts Receivable Factoring Cost
Business owners want to know more about factoring and receivable financing simply because they recognize that cash flow challenges hinder them from growing, and yes, even surviving.
And, we are sorry to say, many clients simply can’t get the bank financing they need to fund and grow their business - that isn't necessarily a condemnation of Canadian chartered banks, it’s a case of individual financing challenges within the current credit crunch and global economic challenges.
Opportunity Cost of Not Factoring
While the nominal fees associated with factoring are often discussed, the opportunity cost of not factoring is rarely considered.
For some businesses, not leveraging factoring could mean missed opportunities for growth or lost discounts from suppliers for early payment. By focusing on the cost of factoring alone, businesses may overlook the potential revenue growth or savings that could have been realized if they had immediate access to the cash tied up in receivables. This can include the ability to take on new projects, invest in marketing, or simply negotiate better terms with suppliers for bulk purchases.
Analyzing Factor Cost
So, let’s cover off what you need and want to know about factor cost and the true way in which you should be looking at the pricing around factoring accounts receivable in Canada.
Key Drivers of Factoring Pricing
There are three; let's call them 'drivers' in the pricing process of financing your receivables in the factoring agreement. Those three drivers are the time in which it takes for your invoice to be paid, and we mean right down to the day when it comes to invoice factoring rates.
Secondly, the factoring firm calls their pricing a 'discount' - so the actual discount rate they quote you becomes critical in your knowledge of understanding your true cost of financing A/R.
Finally, to keep things simple we often explain to clients in the initial discussion that they receive immediate cash for their receivables once they finance them, i.e.a same-day cash advance
The Reality of Receivable Advances
However, the reality is that the industry advances a (significant) portion of your accounts receivables, the rest is a holdback. Typically this portion is 90%, but many firms calculate total financing not just on the holdback but the invoice amount.
Timing of the Holdback Release
When do I get the holdback? Ask clients. The answer is that they receive the holdback as soon as the actual invoice is paid.
The Focus on Discount Rate
We think it's clear that the discount rate, of the three key drivers we have mentioned, is the most focused on by clients. Because the commercial receivable financing industry is not regulated, firms charge what markets will bear.
Discount Rate/Factor Fee: This is the primary cost associated with factoring and is a percentage of the invoice value. It represents the fee charged by the factoring company for providing immediate funds and is often the most significant component of the overall cost. Understanding how this rate is calculated and what it encompasses will give you insight into a large part of the factoring expense.
Advance Rate: This determines how much money you receive upfront and influences your immediate cash flow. Typically, an advance rate is around 70-90% of the invoice value. The remainder, minus the factor fee, is paid to you once your client settles the invoice. This rate directly affects the liquidity you gain through factoring.
Time to Payment (Recourse Period): The amount of time it takes for the factoring company to get paid by your customers affects the receivable factoring cost. The longer an invoice goes unpaid, the higher the fee can be, especially in recourse factoring where the business eventually takes back the risk of non-payment.
Volume and Quality of Receivables: These influence the factoring company’s risk and thus impact the cost of factoring receivables. A higher volume of invoices can lower the factor fee due to economies of scale, while the better credit quality of your customers may reduce the perceived risk, potentially leading to more favourable rates.
Additional Fees: These can include service fees from the invoice factoring company, as well as administrative fees, or penalties for early termination of the contract or for invoices paid late by your customers. Understanding these additional costs is vital as they can significantly impact the overall cost of factoring if not managed properly.
Companies using Confidential a/r financing can realize all the benefits of collecting their own invoices with the same costs as traditional factoring solutions.
Conclusion: Understanding Your Factoring Returns
In summary, understanding the returns of your commercial factor firm will better assist you in determining if this overall receivable financing strategy is for you.
Call 7 Park Avenue Financial, a trusted, credible and experienced Canadian business financing advisor to better understand the benefits of this growing method of financing your company.
What is factoring accounts receivable?
Factoring accounts receivable is a financial transaction where a business sells its outstanding invoices to a factor company at a discount, in exchange for immediate cash.
How does factoring improve cash flow?
To understand how does Accounts Receivable Factoring Work requires focusing on the process of selling your unpaid invoices to a factor, where you receive most of the cash immediately, thus improving your working capital and cash flow without waiting for customer payments.
What is a discount rate in factoring?
The discount rate is the fee that a factoring company charges for providing immediate cash in exchange for your invoices. It's a percentage of the invoice value.
Is factoring a loan?
No, invoice factoring is not a loan. It's the sale of your accounts receivable at a discount to an invoice financing company for immediate cash.
What are the risks associated with factoring?
The main risk is the potential cost of factoring fees / factoring rates, which can be higher than traditional financing if not managed properly. There's also the reliance on your customers' creditworthiness since late payments may increase fees on the invoice factoring cost. Managing asset turnover and days outstanding in receivables reduces financing costs.
Can any business use factoring for its accounts receivable?
Most businesses that generate invoices can use factoring services, but it's best suited for those with reliable customers and a steady volume of accounts receivable who might not be able to access approval for a bank line of credit.
Are there different types of factoring services?
Yes, there are two main types: recourse and non-recourse factoring. Recourse factoring requires the business to buy back unpaid invoices, while non-recourse does not - in the latter the factoring company accepts risk for bad debt and collection.
Does factoring affect my business's credit rating?
Factoring doesn't typically affect your credit rating as it's not a loan. However, it requires your customers to have good credit since their payment history impacts the factor's risk.
How quickly can I receive funds through factoring?
Funds from factoring can often be received within 24 to 48 hours after the factor has approved your invoices for purchase.
Can I choose which invoices to factor?
Yes, many factoring companies allow you to select specific invoices to factor, giving you control over your financing needs and costs.
How Can Factoring Be A Strategic Credit Management Tool?
Factoring is frequently viewed as a financing tool, but it can also be a strategic element in managing a company's credit risk.
By selecting a factoring arrangement with recourse, a business can effectively outsource its credit control and debt collection processes, which may reduce overhead costs and mitigate the risk of bad debt. In contrast, non-recourse factoring can serve as a form of credit insurance, protecting a company against customer insolvency.