The Case for Factoring: More than a Last Resort

A staffing company in Eastern Virginia began taking on contracts in 2021. They offered medical staffing and grew rapidly. This created a need for cash. Being a staffing company, they didn’t own many hard assets, and so they turned to factoring, to which their accountant responded: “You really chose this over a line of credit?”

Perhaps you have never heard of factoring. Perhaps you have heard of it, and would have the same reaction as the accountant. Either way, we hope to shed new light on this financial tool, and start reframing the perception among financial professionals.

The Perception Problem

Often, we hear factoring described as “the loan of last resort” or as “payday lending for businesses”. Some even assign the word “usury” to factoring. The common thread throughout these designations is the idea that factoring is a type of loan. The consequence of this idea is that financial professionals will often compare factoring to lending on the same terms. While this comparison is valid to a point, since both lending and factoring can serve similar needs, it ignores the substantial differences in how each tool meets the need.

What is Factoring?

For those unfamiliar, factoring is the sale of commercial accounts receivable to a factoring company at a discount. The factor pays the business 80-90% upfront for the receivable and then collects from the business’ customers. Once the factor collects payment, they remit the remaining 10-20% back to the client, minus a processing fee. This fee often amounts to 1-6% per receivable. With bank owned factors, that range can drop to 1-3%.

Is Factoring a Type of Loan?

The short answer is no, factoring is not a loan, legally or functionally. The long answer dives into UCC law, GAAP, and historical court interpretations, and goes far beyond the scope of this article. The short answer is that factoring is the sale of a financial asset, whereas lending is borrowing against assets. A loan infuses a company with new money; factoring speeds up a business’ own cash conversion cycle by purchasing the receivable.

Factoring: More Expensive = Last Resort?

Factoring and commercial lines of credit serve similar needs. If one annualizes factoring fees, they often amount to more than the average interest rate (see the discussion of factoring costs later on).

So if factoring fills the same need at a higher cost, wouldn’t that, by default, make factoring a last resort? Not necessarily. Cost alone does not determine where a tool fits—need does. Consider the following illustration:

A man compares hammers and nail guns at the hardware store. Both tools can accomplish the same basic goal—driving nails. So, after noting the price difference of $25 to $200, he walks out of the store with a hammer.

Is this the best choice? It’s impossible to determine without knowing his needs. If he’s hanging a picture, the hammer is perfect. If he’s building an addition, he’s going to be back for the nail gun.

Both tools accomplish similar goals and meet similar needs, but they excel in different contexts. Just because one is more expensive does not automatically make it the last resort. It can be a strategic move if the need calls for it.

What Needs does Factoring Fill?

So, if factoring is not necessarily a last resort, it is important to ask where it can be a strategic move. In our experience, factoring can be a strategic move for high-growth or seasonal companies or companies with few or leveraged assets.  If they have a balance of commercial accounts receivable for credible, but slow-paying customers, it can be a great fit.

That’s a mouth full, so let’s break it down:

High-Growth & Seasonal Companies

High-growth and seasonal companies use factoring for its scalability and flexibility. A business’ AR volume directly determines how much capital it can access through factoring. The more they sell, the more they can factor. Where conventional underwriting examines past performance, factoring considers a business’ present condition. This is critical for high-growth and seasonal businesses. A company may generate $100K/month from January to September, but then jump to $500K/month in the last quarter. The need for working capital rapidly increases, but a line of credit can’t jump that quickly. Past performance can’t gauge the current needs. Factoring, on the other hand, scales with sales, allowing businesses to grow without running out of cash.

Few or Previously Leveraged Assets

Traditional bank lending depends on real estate and other hard assets. Many service companies, such as staffing, consulting, or trucking, have very few hard assets (or their assets are already leveraged). These companies still need working capital to cover projects while they wait for payments. Since factoring is the sale of AR, it doesn’t matter if a company has real estate or not—only that they’re generating receivables. This can make factoring the best fit.

Receivables for Slow-Paying Customers

Slow-paying customers are the bread and butter of factoring. This problem alone is enough for a business to consider factoring. Some large, Fortune 100 companies have terms of 120+ days. Four months without payments is hard to float and terribly inflates the cash conversion cycle. Many businesses simply cannot afford to float receivables for that long. Even if they can, they’re missing out on the opportunity cost of using that cash elsewhere. In these scenarios, factoring can truly be the best (and sometimes the only) option.

The Elephant in the Room: The Cost of Factoring

Granting that factoring is useful in certain contexts, it is important to understand the costs and measure them against other options. Cost is perhaps the biggest reason accountants often advise their clients to avoid factoring.

Factoring can cost anywhere between 1-6% per receivable (this includes auxiliary fees such as ACH, wire, maintenance fees, etc.). The factor may charge all or a portion of these fees upfront, or accrue the fees through a daily rate until the invoice pays. Regardless of what makes up the 1-6%, or how the factor charges it, accountants often annualize this fee. Depending on the turn of the AR, this could amount to a pretty hefty annualized percentage rate. Consider the following chart:

Days Outstanding	1% Fee	6% Fee
30	12%	72%
45	8%	48%
60	6%	36%
90	4%	24%
120	3%	18%

A 72% APR is exorbitant. In reality, yields for factoring companies often fall between 8-24%. Some industries are higher, such as trucking or construction due to risk and scale. Regardless, taking this average as the standard of comparison to the average line of credit cost of 8.25%, and it’s easy to see that factoring is the more expensive tool. This we concede. If a line of credit can meet a company’s needs, and they qualify for it, they should not opt for factoring. Similar to the previous illustration—if a hammer meets the need, there’s no need for a nail gun. However, this is not the end of the story. If a builder needs a nail gun, paying for a hammer will only lead to frustration and inefficiency.

Factoring Costs & Benefits

The cost of factoring must be justified by the need, and ideally, offset by the benefits. As a financial professional potentially advising businesses on their course of action, it’s important you understand more than just the face value costs and benefits of factoring.

If a business could grow by 25% in 12 months with faster cash flow, then that covers the costs. In some cases, the opportunity cost of not using factoring outweighs the fees. Additionally, some companies could use the excess cash flow to take advantage of supplier discounts, offsetting costs even further. Lastly, for some business owners, the peace of mind knowing that there is cash in the bank is a benefit unto itself.

Factoring vs Lines of Credit: Not an Ideal Comparison

We have been comparing to a line of credit, mostly because that’s the most common comparison you see in the marketplace. But factoring and lines of credit operate differently, and thus one cannot compare them perfectly. Consider the following illustration.

We can agree that cash is business fuel. Without cash, a business is not going anywhere. Lending is like pouring gasoline into a car—it gets things going, but once it runs out, it’s gone. Factoring is like a fuel pump to an engine. It’s not the fuel itself, but it allows the fuel already in the tank to pass quickly into the engine to keep the car running. With lending, a business is paying for cash. With factoring, a business is paying for speed. A business could pay 8.5% for an influx of $100K, or 3% to speed up the $1.2M over the course of a year. Essentially, comparing lending to factoring is comparing a product to a service.

Considering this functional distinction, one could argue that calculating an annualized rate for factoring misses the point. Of course, a one-time product would cost less than an ongoing service, but sometimes a onetime product doesn’t cut it. A better comparison to factoring is a business accepting credit card payments or offering quick pay discounts. These tools are functionally more similar to factoring than a line of credit, and are readily accepted by businesses with little hesitation. However, you rarely see the costs of these tools and services annualized. Doing so makes it clear that factoring truly is a cost effective service.

Factoring Compared to Credit Card Acceptance

Credit cards are so similar to factoring that some even consider Visa and Mastercard to be quasi-factoring companies. Consider the similarities. When accepting credit card payments, a customer purchases goods or services on credit, and the merchant pays 1.5-3.5% to get their money same day. In the factoring model, a customer purchases goods on credit, and the business pays 1-6% to receive money same day.

These fees may not seem comparable at face value, but annualizing clears the water. Best practice is for customers to pay off credit card debt after 30 days—some business cards even require this. Standard invoice payment terms are also 30 days. Thus, we assume that the alternative to accepting credit card payments is to use invoice terms, and thus the merchant pays 1.5-3.5% to receive payment 30 days early, or 1.5-3.5% every 30 days. This makes the annualized rate of accepting credit card payments 18-42%, which makes factoring, on average, less costly.

Factoring Compared to Quick Payment Discounts

Quick payment discounts again serve the same purpose of speeding up receivables. The most common form of quick payment discount is 2/10 net 30. If the customer pays within 10 days, they receive a 2% discount. Essentially, a business is paying 2% to have their money 20 days sooner, which makes the annualized rate of a quick pay discount 36%. Again, this makes factoring, on average, the cheaper and more predictable option.

So, while factoring is more expensive than lending at face value, when compared to other tools and services that perform similar functions, factoring shows itself to be a cost-effective tool for speeding up receivables.

Why is Factoring Known as a Last Resort?

We believe there are two primary reasons for this. The first is that factoring can and often does function as an excellent last resort and thus there are many struggling companies that depend on factoring. Underwriting for factoring focuses primarily on the payor of a receivable rather than the originator. This allows companies with poor credit (but strong customers) to access financing to keep afloat, which leads many companies to use factoring as their last resort. However, while the method of underwriting allows for factoring to be an excellent last resort, it does not make factoring only a last resort.

The Self-Perpetuating Stigma

The second reason we believe many consider factoring the last resort is because of a feedback loop. If one perceives something as a last resort, it becomes a last resort. Perceived as a last resort, factoring can carry a stigma. Companies don’t want to send the wrong message to the marketplace. Thus, companies put off using factoring to preserve their reputation, even when it could have helped stabilize their cash flow months before. This creates a feedback loop—companies avoid it until it becomes their last resort.

Further, predatory factoring companies exist, and further the stigma. If a company is desperate, they’re more susceptible to falling prey to a bad financing partner. Regardless, many good factors exist, and support struggling companies, even serving as a stepping stone or incubator until a business is ready and able to qualify for traditional credit.

The Final Hurdle: How You Can Help

Ultimately, we hope this article has helped show how invoice factoring really is a helpful tool that should be considered in a business’ capital stack. We believe that about 15% of businesses in the US could benefit from this service, but so few even know it exists. Public perception is perhaps the greatest hurdle holding back factoring and, by extension, holding back businesses that could benefit from factoring. This is a difficult hurdle to overcome, but the more accountants, bankers, financial advisors, and other business professionals see factoring as a valid tool that meets a specific need, the more it can be used to help companies grow and thrive.