Factoring can be a very useful financing tool for companies at an earlier stage that are not quite ready for more prime time lending such as a bank line of credit.

 

When I was head of finance and operations for Kidco, an early-stage toy manufacturing company,  we used factoring to grow faster than we could have otherwise from just our own cash flow.  Rather than having to wait for the money to come back in collections, we got money sooner from the factor and put that money to use in our operation. 

 

A factor is somebody who will buy your receivables from you and then pay you a percentage on the accounts.  The money is normally collected by the factor and then they settle up with you at that point.

 

The issue is that factoring might turn out to be a higher cost than you really anticipated.  What you see at face value is not the true cost of factoring.  The adjustment may be different than you think.

 

Here is another situation that I saw recently.  In this case, the rate charged by the factor to the manufacturer was 1% for every 10 days.  That meant that as soon as an account hit 11 days, another 1% was charged.  Same for when it hit day 21, and every 10^th day thereafter.  Fortunately, at this manufacturer, they collected in 15 days on average.

 

Below is a table showing the stated rate calculation, and the adjusted rate calculation based on the actual average collections at this food manufacturer.

 

Face Value Calculation
Factoring Days	10
Factoring Rate	1%
Effective Interest	36%
Adjusted Calculation
Average Days AR	15
Factoring Rate (2 periods)	2%
Effective Interest	48%

 

As you can see, the adjusted rate, based on the actual collections, turns out to be much higher.  Factoring turns out to be much more expensive than first seen at face value.

 

If you are factoring, make sure you understand that part of the calculation.  If your rate is higher than you want, see if the days used in the calculation is negotiable.  If not, you might want to consider bringing in more equity or seeing if one of your investors would loan money to you at an interest rate that is much higher than what they could normally get, but below the cost of factoring.