The most a business can afford to pay for financing, on a sustainable basis, (whether from a factoring company or any other source)is the difference between gross revenues and all non-financing related costs, including a return to the owners.
A business can run a deficit for a while. Owners might be able to forgo returns for a while. And non-cash costs can be ignored for a while.
But in the long run, if the business model does not generate enough "room" to pay for outside financing; taking on outside financing is going to cause problems.
There are three principal issues to consider in deciding how much outside financing a business can reasonably support:
a) the amount of the financing,
b) the return required by the financing source, and
c) the length of time the funds will be needed.
In the factoring business it's not often the case that the AMOUNT of financing provided gets a business owner into trouble. That's because the amount of money advanced by a factor will be a percentage of the accounts receivable.
If the receivables bear a reasonable relationship to sales and assets and the factor's advance percentage is typical, the size of the financing should not be large enough, in itself, to get anyone in trouble.
The return required by a factoring company, in the same way, should not be the source of a problem. The reason is that it's a known quantity.
Whatever the rate is: however high or low it might be; in the spot-factoring business especially, it's no secret. Both parties know what the periodic cost of funds will be.
No. In my experience, the source of almost all problems of affordability is TIME.
I'm not talking about other things that might go wrong in a transaction or a relationship. I'm talking about an affordability problem that comes about either as a surprise or through self-delusion.
Those problems arise when payments are late. Because when payments are late, costs rise.
If the payments are late enough the entire margin available for financing costs can be exceeded, sometimes pretty quickly.
If a financing facility has been structured and appears comfortable to all based on receipt of payments in 30 days, and all of a sudden payments are taking 90 days, the cost of financing can overwhelm a business owner.
And when business owners get overwhelmed problems of all sorts can arise.
I've had the experience of "word getting around" that I target a 45-day payment cycle only to find that every prospective client I talk to expects to paid in 45 days! When we actually look at an aging report it often becomes apparent that the 45-day cycle is a fantasy.
Here's the message of the day: It's all about time.
The quickest way to get into trouble is not a function of the rate you're paying; it's a function of kidding yourself about how long you'll have to pay the rate.
An annual rate of 100% might seem quite reasonable if the transaction is only open for a few days.
But a rate of 20% can be ruinous if you've deluded yourself about how long it has to be paid.
It's about time! Not rate.
Showing posts with label Spot Factoring. Show all posts
Showing posts with label Spot Factoring. Show all posts
Tuesday, February 8, 2011
Wednesday, June 23, 2010
The Cost of Factoring # 2
In my last post I continued to explore the differences among the basic types of factoring relationships.
The traditional full-line factoring relationship typically involves more money, minimum required transaction volumes, minimum required commitment periods, a broad array of services and better credit.
Spot factoring, on the other hand, typically involves smaller transactions, no required minimum time periods, no required volume commitment, weaker credit and, essentially, a single service.
The cost in time and effort to establish a traditional factoring relationship can be recaptured over a known minimum period of time and volume of transactions. This leads to a pricing structure that is more closely related to the factor’s cost-of-funds. Frequently these relationships will require a basic cost-of-money element stated in terms of a spread over the prime rate, but they will also typically include a range of service fees.
For example: there might be a fixed additional fee applied to each invoice purchased, a processing fee for collections, an accounting and reporting fee and fees for all money transfers. An annual account maintenance fee might include the costs of analyzing required updates of the client’s financial statements and new credit reports and UCC searches.
While the stated cost-of-funds in such a relationship is an easily understood item, the total cost of the relationship has to be evaluated in light of the charges for the various services provided.
The spot factoring company, on the other hand, because it’s pricing is predicated on a single transaction rather than a longer-term commitment, will most often quote an “all-in” fee based on the face amount of the invoices being purchased.
The cost-of-funds element of the spot factor’s pricing will typically be a smaller component of the total cost than would be the case for the traditional full-line factor. That is because the spot factor has to accept the possibility that it will complete only one transaction with a prospective client. If that is, in fact, the case, the time and effort required to establish the relationship and close that single transaction will be a much larger element of its cost than the cost-of-funds itself.
In fact, the spot factoring company will almost always lose money on a single-transaction relationship.
We are all accustomed to converting costs in a financing relationship to an annual percentage rate. And most of us have certain benchmarks; like the interest rate on a car loan, a home mortgage or a credit card; against which we measure those costs.
In factoring relationships those benchmarks are of minimal value.
In the case of full-line factoring, the benchmarks have minimal value because of the range of services provided in addition to the value of the funding itself.
In the case of spot factoring, the benchmarks have little value because the nature of the relationship and the costs associated with it bear little resemblance to the relationships in our normal benchmarks.
Especially in the case of spot factoring, the cost that is most important to analyze and understand is OPPORTUNITY COST.
That is, answering the questions:
a) What is the value of the opportunity that the factoring arrangement allows me to pursue that I could not otherwise pursue? or
b) What costs can I AVOID by having the money owed to me NOW rather than, say, 45 or 60 days from now?
I’ll address the opportunity cost issue in my next post.
The traditional full-line factoring relationship typically involves more money, minimum required transaction volumes, minimum required commitment periods, a broad array of services and better credit.
Spot factoring, on the other hand, typically involves smaller transactions, no required minimum time periods, no required volume commitment, weaker credit and, essentially, a single service.
The cost in time and effort to establish a traditional factoring relationship can be recaptured over a known minimum period of time and volume of transactions. This leads to a pricing structure that is more closely related to the factor’s cost-of-funds. Frequently these relationships will require a basic cost-of-money element stated in terms of a spread over the prime rate, but they will also typically include a range of service fees.
For example: there might be a fixed additional fee applied to each invoice purchased, a processing fee for collections, an accounting and reporting fee and fees for all money transfers. An annual account maintenance fee might include the costs of analyzing required updates of the client’s financial statements and new credit reports and UCC searches.
While the stated cost-of-funds in such a relationship is an easily understood item, the total cost of the relationship has to be evaluated in light of the charges for the various services provided.
The spot factoring company, on the other hand, because it’s pricing is predicated on a single transaction rather than a longer-term commitment, will most often quote an “all-in” fee based on the face amount of the invoices being purchased.
The cost-of-funds element of the spot factor’s pricing will typically be a smaller component of the total cost than would be the case for the traditional full-line factor. That is because the spot factor has to accept the possibility that it will complete only one transaction with a prospective client. If that is, in fact, the case, the time and effort required to establish the relationship and close that single transaction will be a much larger element of its cost than the cost-of-funds itself.
In fact, the spot factoring company will almost always lose money on a single-transaction relationship.
We are all accustomed to converting costs in a financing relationship to an annual percentage rate. And most of us have certain benchmarks; like the interest rate on a car loan, a home mortgage or a credit card; against which we measure those costs.
In factoring relationships those benchmarks are of minimal value.
In the case of full-line factoring, the benchmarks have minimal value because of the range of services provided in addition to the value of the funding itself.
In the case of spot factoring, the benchmarks have little value because the nature of the relationship and the costs associated with it bear little resemblance to the relationships in our normal benchmarks.
Especially in the case of spot factoring, the cost that is most important to analyze and understand is OPPORTUNITY COST.
That is, answering the questions:
a) What is the value of the opportunity that the factoring arrangement allows me to pursue that I could not otherwise pursue? or
b) What costs can I AVOID by having the money owed to me NOW rather than, say, 45 or 60 days from now?
I’ll address the opportunity cost issue in my next post.
Thursday, June 10, 2010
The Cost of Factoring #1
In my last post I wrote about the differences in expected duration among the three basic types of factoring relationships. And I concluded with the point that those differences also caused the pricing of each to vary.
My next few posts will address the issue of pricing.
In any kind of financing relationship there are several elements that affect cost: size, duration, cost of origination and servicing, and risk of default, for example. And, of course, the provider of the financing has its own cost of capital to cover.
I started my career in the commercial mortgage business. One of the first things that I was taught was that it takes as much work to make a $1 million loan as it does to make a $10 million loan. Essentially the origination process is the same regardless of size. So, the smaller the transaction, the higher the relative cost of origination.
In the same way, the shorter the duration of the loan, the greater the impact of origination cost. Recapturing origination cost over one year will obviously require a relatively higher rate than recapturing that cost over ten years.
The same general issues hold true in the factoring business. Even though the duration of factoring relationships isn’t as long as those of mortgage loans, the principle is the same.
The longer duration of the traditional, full-line factoring relationship, allows pricing to be relatively lower because the factor’s costs are recaptured over a longer period.
In the case of a spot-factoring relationship, where it is possible that the relationship will consist of only a single transaction, origination costs will represent a larger component of transaction pricing.
The traditional, full-line factoring relationship will also typically involve a significantly higher volume of funds advanced than will the spot-factoring transaction. And the higher the volume, again, the lower the relative cost of establishing the relationship.
I’ve also noted previously that the companies that enter into full-line factoring relationships tend to be larger firms with longer track records and better credit than those that seek spot-factoring relationships.
Those characteristics obviously command lower pricing commensurate with lower risk.
So, the size, duration and credit risk in the typical full-line factoring relationship are significantly different from those in the spot-factoring relationship and those will all affect pricing.
More on this subject in our next post….
The Interface Financial Group has been helping businesses with their cash flow needs since 1971. Solving cash flow problems is what we do.
My next few posts will address the issue of pricing.
In any kind of financing relationship there are several elements that affect cost: size, duration, cost of origination and servicing, and risk of default, for example. And, of course, the provider of the financing has its own cost of capital to cover.
I started my career in the commercial mortgage business. One of the first things that I was taught was that it takes as much work to make a $1 million loan as it does to make a $10 million loan. Essentially the origination process is the same regardless of size. So, the smaller the transaction, the higher the relative cost of origination.
In the same way, the shorter the duration of the loan, the greater the impact of origination cost. Recapturing origination cost over one year will obviously require a relatively higher rate than recapturing that cost over ten years.
The same general issues hold true in the factoring business. Even though the duration of factoring relationships isn’t as long as those of mortgage loans, the principle is the same.
The longer duration of the traditional, full-line factoring relationship, allows pricing to be relatively lower because the factor’s costs are recaptured over a longer period.
In the case of a spot-factoring relationship, where it is possible that the relationship will consist of only a single transaction, origination costs will represent a larger component of transaction pricing.
The traditional, full-line factoring relationship will also typically involve a significantly higher volume of funds advanced than will the spot-factoring transaction. And the higher the volume, again, the lower the relative cost of establishing the relationship.
I’ve also noted previously that the companies that enter into full-line factoring relationships tend to be larger firms with longer track records and better credit than those that seek spot-factoring relationships.
Those characteristics obviously command lower pricing commensurate with lower risk.
So, the size, duration and credit risk in the typical full-line factoring relationship are significantly different from those in the spot-factoring relationship and those will all affect pricing.
More on this subject in our next post….
The Interface Financial Group has been helping businesses with their cash flow needs since 1971. Solving cash flow problems is what we do.
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