How Much Will Factoring Cost?

The most common mistake a person makes when trying to determine the “cost” of factoring is equating the dollars spent on this finance option to an interest rate. If one looks at the definition of factoring (simplified for this example), it is the discounted sale of an invoice. The calculation of the cost of business factoring is, in reality, the amount that the invoices (or claims in healthcare) have been discounted. Other calculations are not accurate and make no sense. This is where healthcare factoring and other types of business factoring can get confusing.

We will use the example that a factoring client (a vendor) does $100,000 in sales to his customers each month and factors every month to accelerate the cash flow. Invoices pay typically in 30 days and for that period of time the factor is discounting the receivables 2.4%. The most common mistake is the following calculation:

2.4% for 30 days equates to 28.8% annual interest (2.4% X 12 months). The error is that the 2.4% discount applies only to the $100K being factored at that time; it has nothing to do with any other transaction that may occur in the future or may have occurred in the past. So to clarify, if the client only factors one time per year, the cost is $2,400 for the discounted sale of an invoice for $100,000 (2.4% of sales). Suppose the client factors 6 times during the year, the cost would be $14,400 for the discounted sale of $600,000 in invoices (2.4% of sales).

Now let’s look at the absurdity of equating a discount fee to an interest rate. Many vendors offer their customers an early pay discount if paid within ten days (called 2% / 10 – Net / 30). Meaning that the customer can take a 2% discount if they pay their bill within ten days otherwise they have to pay full (net) price within 30 days. Suppose the customer pays in 10 days and takes the 2% discount. Using the same invoice amount of $100,000 the customer would take a $2,000 discount and only pay $98,000 for the goods supplied. Convert that in the same incorrect manner as shown above…what would that interest rate be? See Below.

2% for 10 days = 6% for 30 days = 72% per annum…Did the vendor pay 72% annual interest for giving his customer a 2% discount? Of course not, he, the vendor, simply wrote off 2% of the income for that one, single, transaction. If the customer does this once per month, 12 times per year, the customer received $24,000 in discounts for 12 invoices totaling $1,200,000 ….Cost -> 2% of sales!