Factoring Accounts Receivable is Expensive

The case against factoring invoices

First, I should give you a bit of background. I have been in banking for over fifteen years. All of those years have been on the commercial side of banking with an emphasis on credit and backroom support. For the purposes of discussing factoring, you should also know that about 12 years ago I was working for a bank that decided to get into factoring. I was given the responsibility of implementing the program. The program was discontinued after a year because of the amount of fraud that we experienced. Two customers decided to start selling us fake invoices and since our factoring customer base was small, it was enough for top management to decide to cancel the whole experiment.

A little bit about factoring: Factoring is the purchase of accounts receivable (invoices) by a finance company (called a factor). The normal factoring arrangement is usually entered by small businesses that cannot wait for their customers to pay the invoices, and need the cash to fund ongoing operating expenses. The business takes the invoices to the factor and gets a cash advance of 70% to 90% on the invoice amount. Once the customer pays for the invoice, the factor pays the rest of the balance due (the 30% to 10%).

The main difference between a line of credit and a factoring agreement is that the line of credit is granted after underwriting the ability of the business to repay the loan. However, factoring relies on the ability of the customers of the borrower to pay their invoices.

Although my experience in the commercial bank lending arena predisposes me to like regular bank financing due to my familiarity, I am not completely against the idea of factoring. Many businesses’ financial performance and condition are too weak to be bankable. In addition, the idea of non-recourse financing is very attractive to business owners and that is difficult to achieve for small businesses. Nevertheless, the business owner should be an informed consumer, and I hope that this helps the reader makes his mind.

The first reason I dislike factoring as a method to finance business is the cost.

This is not news and most everyone knows that financing operations by selling invoices is a costly method. However, it is sometimes forgotten because the fees are relatively small (anywhere from 1% to 4%). The business owner looks at a prospective deal and sees that the factor will only charge him a 2% fee, and thinks it is a good deal. But once we do the math, you will be surprised at the real cost of that money. However, I am not going to deny that running a factoring company can be a lot more labor intensive than running a bank since a good factor would verify a lot of the invoices that are bought and will remain on top of each customer’s operation.

Let’s assume that the owner of ABC Corporation needs cash to pay his employees or buy some inventory. He just sold some goods for $1,000 to “Large, Inc.” who is a well known regional company. He knows that Large, Inc. is going to pay him, but Large, Inc. usually takes 45 days to pay its invoices, and he needs the money now. The owner of ABC approaches a Factor that is willing to buy the invoice for a small 2% fee and give him an 80% advance on the amount.

 The transaction on day one will look like this:

80% Advance Rate


less 2% Factor Fee


Money into ABC’s account


So far so good, but you need to understand two things. A) The money received was only $780. B) The Factor is going to get repaid in 45 days when Large, Inc. pays the invoice. It is time to annualize the rate, and find out ABC’s real cost of funds.

Actual rate ($20 ÷ $780)


Annualized rate  assuming 45 days


As you can see from the above, ABC is actually financing its operations at a cost of almost 21% per annum.

The second reason that I dislike factoring is that most are not really non-recourse.

There is an understandable attraction to non-recourse financing. However, the truth is that the majority of the factoring arrangements are with recourse. Every single one of the companies that my old bank bought invoices from had the guarantee of the owner, and we could debit their accounts for unpaid invoices after a certain number of days. It is my understanding that this is still the case in the industry.

Buying invoices from financially strong customers carries little risk, but the fact is that once you start buying invoices from small customers it gets dicey. Let’s go back and take a look at our friend from ABC Corporation, let’s assume his accounts receivable look like this:

Large Inc. Customer invoice


Small Inc. Customer invoice


Total A/R


ABC Corp. goes to the factor and wants to sell them both invoices. The factor is willing to buy the invoice from Large, Inc. but his risk appetite is not there for the Small, Inc. invoice so he only purchases the Large, Inc. invoice. The funding looks like this:

Scenario #1

Factor buys Large’s invoice


Advance rate ($780/$2,000)


Funding only 39% of total A/R does not solve the funding needs of ABC Corp. After some discussion, the factor might be willing to buy the Small, Inc. invoice at a higher fee, or the factor might be willing to accept both invoices as long as he can have recourse. Taking into consideration that the fee is already high, chances are giving recourse is the option chosen by ABC Corp. resulting in funding like this:

Scenario #2

Factor buys both invoices


Advance rate ($1,560/$2,000)



If you are interested in factoring to finance your business, you need to understand that it usually is a very expensive financing option that in most cases does not eliminate completely the risk of non-payment from your customers. However, it might be necessary to use it while you are growing your business or during times when regular bank financing is not available. A good businessman should work to make its business bankable and reduce financing costs, which is what people in my industry refer to as “graduating”.

For more information on factoring, you can read these books: Factoring Fundamentals: How You Can Make Large Returns in Small Receivables
or Factoring Case Studies: Learn and Profit from Experienced Small Factors

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