Factoring Large and Small

Factoring is the purchase of accounts receivable, or invoices, at a discount. This investment method has been in existence for literally centuries and is practiced widely across the United States and Europe.  Now, a reasonable question to ask is this, ‘Why would a business owner want to sell his receivables?”

The answer is simple: Waiting 30 or 45 days to receive payment can put a real squeeze on a company’s cash flow. If they make a product or have to meet payroll, waiting that long can mean a cash shortfall when materials are needed for new orders or when payday rolls around.

For the sake of simplicity we’ll use the following example to illustrate a typical and modest transaction. Suppose a factor purchases a $1,000 invoice, gives an 80 percent advance, and charges 5 percent of the face value of the invoice, assuming payment is received in 30 days. Any of these numbers might be higher or lower depending on the transaction.

After providing the $800 advance to the client and waiting 30 days, the factor receives payment for the full $1,000 from the customer. When this payment arrives, the factor repays himself the $800 advanced, keeps 5 percent or $50 as a discount, and rebates  the client the remaining 15 percent, or $150. Thus the client has paid a discount of $50 to receive $950, $800 of which he received immediately.

Meanwhile, what has the $800 in hand enabled the business owner to do? He can buy inventory to make more sales, have cash on hand to take advantage of discounts, provide working capital  to pay bills, meet payroll, pay taxes, or whatever the business might need. No debt is generated, the discount is paid after the cash advance is received, and the cash has enabled the company to increase profits with greater sales volume.

It didn’t take long to discover that factoring  small receivables could generate more income than a broker consultant could earn from the commissions made only referring larger accounts. How? First, there are many small companies out there who can benefit from factoring that large companies will not fund. Second, making more income as a small factor than as a broker consultant  is a matter of simple arithmetic.

Factoring  brokers  typically earn a commission  of 10 percent to 15 percent of the factor’s discount. If a factor earns 5 percent from $20,000 worth of invoices, the factor earns $1,000. A 10 percent broker commission of this $1,000 factoring discount is $100, while a 15 percent broker commission is $150. Thus a consultant will earn $100 to $150 from $20,000 worth of invoices if the factor is making a discount of 5 percent.

However, if this same consultant comes across a client  with only $5,000 worth of invoices  â€” a client the same larger factor would probably reject — and the consultant-turned-small factor makes 5 percent in factoring  discounts  from the $5,000, he earns $250. In other words, he makes $100 to $150 more as a small factor than he does from brokering invoices four times as large.

An understanding of this simple math has inspired many consultants to become investors by factoring small invoices and still referring larger transactions for a fee.