Introduction
An accounts receivable financing loan? We think we have just answered our question on the strategy known as invoice discounting or invoice finance... namely, the part about 'misunderstanding'. Why is that? Simply because technically it's not even a loan... so no debt, no interest paid, etc. Let's explain.
Debunking the ' Loan 'Misconception
Thousands of Canadian businesses sell to other businesses on credit - hopefully, they are creditworthy clients. That's the essence of the accounts receivable discounting solution - you no longer have to wait to get paid, thereby solving the problem of working capital and cash flow shortages for your business. So how does accounts receivable factoring work - Let's dig in.
The Essence of Invoice Discounting
It couldn’t be any simpler, so why is there so much misinformation about this method of Canadian business financing? At 7 Park Avenue Financial, we think it boils down to some of the terminology and the fact that the many firms that offer this type of finance each come at it from a different focus, direction, and daily mechanics.
How Does Accounts Receivable Financing Work? The Role of Terminology in Misinformation
Under the traditional way of accounts receivable financing, you submit your invoice or invoices to your finance firm partner.
Hopefully, you have chosen the right partner... more about that later. After you have submitted that invoice you get immediate funding - typically in terms of a wire transfer into your bank account. The neat news here is that you can do this daily, weekly, monthly, basically whenever you like. And by the way, you are not obligated to do this all the time; it’s your call to implement only the financing you need when you need it.
The Traditional Approach
The fee. Here's where misinformation abounds! The concept of 'financing' is that A/R is a sale of the receivable, not collateralization.
What do we mean by that? Well, typically if you had a bank facility in place for your receivables they take a security agreement that covers the collateralization of your assets, including of course a/r. So the bank is actually 'lending' against that a/r and charging you an interest rate on a per-annum basis. Those bank interest rates are very attractive... if you of course qualify, which is a discussion for another day!
When an accounts receivable financing firm implements the same strategy their documentation states they are 'buying’ your invoice sales, not collateralizing them. They buy those at a discount, hence the term 'a/r discounting'.
Flexibility in Funding Options / Exploring Pricing and Benefits
Riddle me this .. What is the cost of a/r financing in Canada?
So what's the price of that sale? In Canada, it's generally 1-1.5% if you are selling on a 30-day term. In effect, it’s a reduction of 1-1.5% of your business gross margins.
Where misinformation comes in is the fact that most Canadian business owners and financial managers don't understand the fact that they are already absorbing similar costs by in effect being the bank for their own clients. It's an expensive cost of capital. If you have the cash flow out of that sale you could... well... start the process all over, i.e. make another sale, buy more product... and generate additional profits. Instead of waiting 2-3 months for clients to pay, which seems to be happening a lot these days?
Clarifying the Fee Structure
If you are financing your receivables via a bank they of course wish you the best of luck in collecting them - as little due diligence is done on who you are selling to and on what terms. In accounts receivable financing it's incumbent on you and your finance partner firm to focus on a solid turnover of that A/R - it reduces the cost and generates cash flow more quickly.
Example - How To Calculate AR Factoring
Here's an example of accounts receivable factoring cost for a $10,000 invoice with a 90% advance rate and a 1.25% factoring fee:
Invoice amount: $10,000
Advance rate: 90%
Factoring fee: 1.25%
Step 1: Calculate the advance amount
Advance amount = Invoice amount * Advance rate Advance amount = $10,000 * 90% Advance amount = $9,000
Step 2: Calculate the factoring fee
Factoring fee amount = Invoice amount * Factoring fee Factoring fee amount = $10,000 * 1.25% Factoring fee amount = $125
Step 3: Calculate the net amount received
Net amount received = Advance amount - Factoring fee amount Net amount received = $9,000 - $125 Net amount received = $8,875
In this example:
- You would sell your $10,000 invoice to the factoring company.
- You would receive an upfront payment of $9,000 (90% of the invoice amount).
- The factoring company would keep a fee of $125 (1.25% of the invoice amount).
- Once your customer pays the invoice in full to the factoring company, you will receive the remaining $1,000 minus any additional fees outlined in your agreement.
Important notes:
- This is a simplified example, and actual factoring fees and terms can vary depending on the factoring company, your industry, and other factors and most importantly the time it takes for client to pay.
- It's important to carefully review and understand all terms and conditions before entering into a factoring agreement.
- Factoring can be a helpful tool for businesses that need immediate access to cash, but it's essential to weigh the costs and benefits carefully before making a decision.
Sale vs. Collateralization / Differentiating Accounts Receivable Financing
Other key advantages or differences of accounts receivable discounting include the fact that facilities are generally unlimited - if you are generating sales you have constant, daily access to cash flow.
Picking the right partner is critical in A/R finance. Simple documentation and no hidden fees or terms are critical to your success when you use this financing. Our recommended facility is in fact confidential invoice financing, allowing you to bill and collect your own receivables.
Key Takeaways
- Definition of Factoring Accounts Receivable: Understand that factoring accounts receivable involves selling invoices to a third party at a discount to improve cash flow.
- Benefits: Comprehend the primary advantages, such as immediate access to cash and reduced risk of bad debt. Considerations should include costs associated with the financing, customer relationships if Confidential a/r financing is not used, (Notification vs. non-notification) as well as normal credit and collection risk
- Cost Structure: Learn about the structure of factoring fees associated with receivable factoring cost, including discount rates and any additional charges.
- Process: Understand the step-by-step process involved in factoring accounts receivable, from invoice submission to receiving funds.
- Qualification Criteria: Familiarize yourself with the requirements for eligibility, including creditworthiness and the quality of your invoices.
Conclusion:
Unlock the potential of your business's cash flow with the strategic approach of factoring accounts receivable.
Call 7 Park Avenue Financial a trusted, credible and experienced Canadian financing advisor. Clear up the misinformation on this unique method of business financing.
