Wait a minute, are there customers out there that would take a 1% to 4% discount if they paid their invoice within a 24 hour period or the same day? I have never seen a customer take this opportunity and more often the standard early payment discount terms to an account debtor is “Net 30 days 2% net 10”. Very few customers seldom take advantage of an early payment discount and leaves the vendor struggling for cash.
The reality is that early payment terms offered to customers have existed for many years since credit terms have been offered in business transactions and now has extended to consumer transactions. I recently paid an invoice for a doctor’s visit online and it offered a substantial discount for paying before a certain date. It’s a very common practice now for a business to offer some type of financial incentive to pay an invoice earlier than the terms.
The problem is that even with substantial savings, customers prefer to take the longer credit terms offer and leverage on the line of credit offered by the business/vendor. Some account debtors just don’t have the man power to pay an invoice within 10 days to take advantage of the early payment discount.
The solution is to stop offering early payment terms to customers and just get an invoice factoring company. This eliminates the waiting time and will give the business a consistent, reliable cash flow solution on the invoices it needs early payments on. Factoring companies often will accept an agreement whereas the business owner can offer only specific accounts to submit for funding and is not required to factor all of the invoices. This is a great option for the business because it can sell its invoices and pay for a fee only when needed.
Invoice Factoring cost is not an interest rate! The transaction is a buyer/seller agreement whereas the business owner sells an invoice at an agreed upon discounted price. For example, if your factoring agreement says you will sell the invoice at a discounted 3% flat fee, and receive 97% for the sale of your invoices then its 3% regardless. If the business sells once a month an invoice for a 3% fee, its 3% of the invoice amount. If the business sells one invoice a year, the fee is still 3% based on the invoice value.
Incredibly, there are accountants that want to take the 3% and somehow come up with an interest rate based on when the client (account debtor) paid the invoice to the factoring company and has absolutely nothing to do with the invoice factoring cost the business owner is paying. Why? Because the business owner is paying 3% on the invoice amount no matter if the invoice is paid to the factoring company in 1 day, 10 days, 30 days, 60 days or 90 days. The factoring company is still charging a 3% flat fee to the business owner and the business owner is only paying for 3% on the invoice value.
Some confusion may be caused when a factoring company offers tiered fee structures and gives the business owner a price break if the client (account debtor) pays the invoice earlier than expected. For example, instead of the flat 3% fee like mentioned earlier, the factoring company may offer 1.5% for every 30 days the invoice remains outstanding. This give the business owner a price break if the client pays under 30 days. The business owner still pays a fee based on a per invoice transaction fee of either 1.5% or 3% on the invoice amount.
I recently had a CPA multiply the 1.5% x 12 and said the client was paying 18% interest. I explained to him how invoice factoring cost works and he continued to stand by his results. I asked him to calculate what his client (business owner) was paying based on the 2% net 10 days offer to customers if they paid early. I used his formula and based the CPA’s example: You take 2% x 3 (10 day increments) = 6% for 30 days, and if you take 6% x 12 = 72% interest based on the CPA formula.
In summary, you cannot calculate an interest fee based on a single transaction based fee, otherwise why not calculate interest on the ATM transaction fee of $2.00 for drawing $50.00 on a single day interest calculation. Can you imagine the interest calculation on a cash paying customer that received a 10% discount for paying cash upon receipt? What about calculating an interest rate on 5% discounted invoice that sold on net 30 day credit terms? Discounted product or discounted invoices for early payment are a cost per the transaction and should never be calculated as interest.
As a business owner is if you don’t solve an inconsistent cash flow problem in your business you will miss out on vendor discounts, have delinquent payables and late payroll for your employees, and eventually run out of money for fixed expenses and growth opportunities. As a business owner evaluating cost of either factoring invoices with a reliable positive cash flow or not, the real answer is only the business owner can put a price tag on that.