How do you justify the expense of invoice factoring?
Invoice factoring is an excellent tool to fund the growth of your business for short to medium time frames if the economics make sense. Commodity sourcing usually does not work out because the margins are small but service industries, services mixed with sourcing, and high end product sourcing businesses have the types of margins that work well with factoring. The basic concept of factoring is that you make a lot of points on a transaction, the factor makes a few points, and you use the factor’s money to make a transaction happen. Without the factor you would not be able to fund the transaction and would have to pass on new opportunities.
It all comes down to what your margin is on your transactions. As an example, if your gross margin is 30% and you get paid every two months then you are making a return over the year of 180% on your invested funds (6 times 30%). If factoring costs 1.75% per month then the factoring cost over 60 days would be 3.5% giving you a return of 26.5% on a transaction (30% minus 3.5%) or almost 160% over the year. Keep in mind that the actual return is much higher because you are using someone else’s money to make money.
On the other hand, if your margin is very small, say 5%, then invoice factoring does not make sense because the cost would eat up your profits. The key is that you are comfortable with the return that you will get using someone else’s money and in doing so helps move your business to the next level.