What is Factoring / AR Financing / Account Receivable Financing / Freight Bill Financing?
Factoring, AR Financing, Account Receivable financing are all the same product. They just go by several different names in the industry.
They are the purchasing of account receivable for immediate cash. Factoring/ARFinancing/Account Receivable Financing/Freight Bill Financing gives businesses the power to ensure growth without diluting equity or incurring debt. After invoices are submitted and verified, they are funded within 24 hours.
There are several different types of advances and you need to understand them before you decide on which product to use. Different companies will push different products in order to make more money. You need to know how this works so you can best manage your business.
1. Straight Discount Method
- The SDM as we call is the most expensive but can be very useful if you absolutely need the money ASAP. This is the scenario where you call your ARFinancing company and ask them to buy your invoices. They say they will give you 95% of the money and take the other 5% as their fee.
Now you have your 95% and you are able to pay fuel costs, labor and of course food and housing too. Now let’s look at that other 5%. What is happening to that money? First, if you had carried those invoices for 60 days, then this would average around 2.5% per month for the 60 days. That is not a bad rate and is close to the average you would normally pay. If you rant 2.5% for 12 months that is 30% over a year or 30% APR. That is not a bad deal.
The problem is you just paid 5% for an indefinite period of time. You have your 95% and now the company who bought your invoices, has no incentive to wait 60 days for their money. They want their many as quickly as possible. They are going to call your client and try to get them to pay in as little time as possible. The fast they can collect on the account receivables that they just financed, the more money they make. If they get their money in 10 days, their return on money is 360%, if they get it in 5 days their return is 720%. Do you see now that it is in their best interest to collect that invoice they just factored for you as soon as possible?
This has it pros and cons for you as a business owner. First the pros:
- If you absolutely need all or most all of your money today and can’t afford to wait.
- You don’t have to worry about accruing fees or having the company call you every couple of days.
The cons are a bit more concerning:
- You are paying very high rates if they collect their money faster. Remember, you don’t want to have to lose more than say 3% per month on average. Getting your money in this manner you may pay up to 10 to 20% per month. That is a lot of money.
- Your client base may not appreciate your factoring company, freight bill financing company hammering them for payment.
- It may adversely affect your client base where customers may not want to do business with you anymore.
Bottom line: This product is best for you if you absolutely need all or almost all of your money. If you can possibly wait, then using a different factoring product would be best.
2. Fee Based Factoring/Account Receivable financing
This is your traditional factoring product. There are several methods but the most basic and most used is this. You need to sell your invoices. You need cash very soon or you just don’t want to hassle with having to collect on invoices that might take your client 30, 60, 90 days to pay you back.
You call a company like ARfinancing.BIZ. You ask them for the rates. Based on your clients credit, the age of your invoices, the amount of your invoices, you are given a rate. This rate is reflective of the risk we perceive from the invoices.
Remember the following items are going to affect the rate you will receive:
- Age of Invoice – As the invoice ages, it losses its value. If you have an invoice that is 90 days old, there is a smaller chance that that invoice will be collectable without a lot of calling and collections service. Therefore the rate for that invoice is going to be higher (risk/return). If you have an invoice that is 3 days old on a net 60 invoice. The rate should be lower because it is a young, fresh invoice with a lot of promise that it will be collectable.
- Amount of Invoice – Some companies do not have minimums but all companies have cost of funds, labor, and fees that need to be earned in order to make money. It is not set in stone, but in general, the smaller the invoice, the higher the fees are going to be.
- Company responsible for paying the invoices - Example: Wal mart, Target, Macy’s are big names with well established credit. If you have invoices to these types of companies, you are likely to get a better rate on your AR Financing.
- For truckers, your invoice is a Freight Bill usually based on the time, fuel, labor and trucking costs of getting a product from A to B in the shortest, safest amount of time. This typically does not have an affect on your advance rates, fee rates, etc…
An asset based business line of credit is usually designed for the same purpose as a normal business line of credit - to allow the company to bridge itself between the timing of cash flows of payments it receives and expenses. The primary timing issue involves what are known as account receivables - the delay between selling something to a customer and receiving payment for it. A non asset based line of credit will have a credit limit set on account opening by the account receivables size, to ensure that it is used for the correct purpose. An asset based line of credit however, will generally have a credit limit that fluctuates based on the actual account receivables balances that the company has on an ongoing basis. This requires the lender to monitor and audit the company to evaluate the account receivables size, but also allows for larger limit lines of credits, and can allow companies to borrow that normally would not be able to. Finally, an asset based line of credit charges an interest rate high enough and has other terms which generally allow the lender to profitably collect the money owed to the company should the company default on payments to the lender. The most extreme form of an asset based line of credit is known as factoring, where the company sells off its receivables so that now its customers owe the lender. The lender mitigates its risk by controlling who the company does business with to make sure that the company's customers can actually pay.
Lines of credits to even riskier companies may require that the company deposit all of its funds into a "blocked" account. The lender then approves any withdrawals from that account by the company and controls when the company pays down the line of credit balance.” (Wikipedia)
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