Factoring: Too expensive?

Much is said about the high cost of factoring and there is some truth to these claims. Two to six percent over thirty days is a lot when compared to the annual interest rates banks offer. However, comparing factoring to a bank loan is flawed comparison from the start as outlined here. In addition, with the current lending environment so tight, less expensive forms of financing may not be available. Comparing the cost of factoring to the funds your business cannot qualify for is not realistic. A better way to determine if factoring is expensive is by considering how the funds will be used.

Factoring is best suited for growing companies for many reasons. First, the amount of funding that a factor can provide is based entirely on sales. Because of this, growing companies can use factoring as a source of funding that will grow with their business as opposed to more traditional loans or lines of credit that will inevitably run out. As well the funds from factoring are ideal for financing sharp increases in sales volume. If factoring allows your business to handle more sales then factoring is directly increasing your top and bottom line. If cash flow issues are the reason your business is turning down sales then it is likely more expensive to not be factoring.

Another great use factoring funds is to take advantage of volume discounts and/or early payment discounts.  This can effectively offset the cost of factoring which essentially means your business could take advantage of some of factoring’s peripheral benefits for free. These benefits will outsource essential duties allowing you to focus on your core business.

These are some of the examples of situations where factoring makes financial sense. However factoring is not always a good fit, and in some situations may be ‘too expensive.’

Factoring almost never a good fit for businesses that have extremely low margins; factoring simply cuts into too much of the profits. If you are factoring at 3% and your margin is 12%, your profits are cut by 25%. This means you will have to raise your sales dramatically just to break even. In this situation, spot factoring might be useful when cash gets tight but a full on factoring arrangement will prove to be too expensive.

Factoring is also not a good fit for businesses that have declining sales. If the ship is sinking factoring will not help for long. However, factoring can work for companies that are restructuring and just need a short term cash flow solution in order to successfully change directions.

To answer the question posed by this blog post, ‘expensive’ is a relative term; factoring is expensive compared to what alternative? If the alternative is not factoring, there are examples above that outline when factoring is profitable and when it is costly. If the alternative is other forms of financing then only the alternatives that a business can actually qualify for should be considered. The point being, labeling factoring as “too expensive” in all situations is too simplistic. Factoring is a financial tool, and as with all tools, they are useful in some situations more than others. Not fully understanding when factoring is beneficial can cost your business dearly.