The following is an excellent explanation of the distinction.
When compared to the Early Payment Discount
The most direct comparison for Invoice Factoring is the early payment discount offered to customers by many businesses. Traditional terms for early payment are 2/10 Net 30. This means that the customer can deduct 2% from the face value of the invoice if payment is made within 10 days of receipt. Otherwise, they must pay the entire amount within 30 days.
This is exactly what invoice factoring does without giving the customer the option to accept the discount. There are some benefits to taking this approach. One is that the end user does not become accustomed to the concept of a discount. As a result, when a company no longer needs to factor its invoices, that 2% goes straight to the bottom line.
Here's another reason why factoring is a good idea. Some businesses will refuse to accept a 2% discount and will instead pay in 30 days. This completely defeats the purpose of the discount.
These two negative consequences are eliminated by factoring.
When compared to accepting credit card payments
At its most basic, invoice factoring is a method for a business owner to collect immediate payment from customers who cannot or do not wish to pay in cash. In the world of consumer-based businesses (and some commercial transactions), this is accomplished by accepting credit card payments. Credit card merchant processing fees range from 1.75% to 4% of the transaction value. The actual transaction fee is affected by the type of card, bank, volume, and so on.
Square, for example, charges a 2.75% transaction fee. [Square is the company that allows you to turn your phone, tablet, or computer into a credit card processing device.]
Invoice factoring is a transaction-based process as well. The service fee on a typical invoice factoring transaction would be between 2% and 2.5%. (depending on the specifics of the transaction). That is less than accepting credit card payments.
When compared to bank lending
The distinction between factoring and bank lending is analogous to the distinction between buying and renting. Bank lending is a lease payment. When you borrow money from a bank (or use a credit line), you must pay it back in full, plus a little extra. The interest rate is that extra. This is comparable to the cost of renting a car. When you're finished using the unit, you must return it and pay for the privilege of using it. The same is true for a bank loan. You have the right to use the bank's money, but you must return it when finished and pay for it.
Because you did not borrow money with Invoice Factoring, you have nothing to repay. You sold an asset to the factoring company, which was an invoice from your company's Accounts Receivable. (Typically, the A/R report contains multiple unpaid invoices at any given time.) That asset (the invoice) is contingent on your customer fulfilling their obligation to pay for product and/or service. As a result, the factoring company receives its money back when your customer fulfills his or her obligation.
Converting a discount rate (such as the above-mentioned early payment discount) to an interest rate is a one-of-a-kind calculation. It is not an easy task. Because the """"discount"""" is applied against revenue rather than a fixed borrowed amount, multiplying the discount rate by 12 months does not reflect the true cost of money. In contrast, an interest rate is applied to a borrowed amount.
Assume you sell $100,000 in invoices to a factoring company each month. Let us also assume a 2.5% discount rate on each invoice. [By the way, that is on the high side.] In a year, the factor would receive $1,200,000 in future revenue. Money would cost $30,000 [2.5% of $100,000 = $2,500 x 12 = $30,000].
To calculate a comparative value for borrowed money, multiply the interest rate of the lender's offer by $1,200,000. This is how it appears. The Lending Club, for example, recently advertised an interest rate of """"as low as"""" 5.9% per year. At 5.9%, the annual cost of borrowing money on $1.2 million would be $70,800. If that revenue was taken into account, the cost of money would be $30,000.
Understanding the difference between an interest rate and a discount rate necessitates a different perspective on the financial transaction. """"Money Cost"""" is not a direct comparison. Using cost of money as the primary reason for choosing between two financing models is detrimental to the business owner. As mentioned in previous articles in this series, the decision is better based on other factors:
Can the company even get bank financing?
Should the company avoid taking on new debt at this time?
Is the owner's autonomy affected by borrowed money (or equity infusion)?
Financing, whether through invoice factoring or bank lending, is only temporary. It is a business growth support mechanism. As a result, a business owner should evaluate his or her options in light of the current business environment and select the solution that will get them the furthest the quickest."""