The costs behind invoice finance – why it’s fair value for clients
I am regularly asked why the cost of accounts receivables financing is higher than the cost of other forms of business funding.
A fair question and one I have no problem in answering.
Traditional financiers (banks) use fixed assets as security. We on the other hand can finance off floating assets (accounts receivables/inventory etc).
And floating assets…well they can float right away. So part of the answer is risk.
This can be a little bit hard to swallow for business owners, because few owners consider their businesses to be risky. But the fact is that all business is risky. Start ups and small growing businesses, our typical clients, tend to be quite risky ventures.
When we start buying invoices, we have to assume that some will not be paid. In other words, we can lose their capital for those specific invoices. Here are some numbers (hypothetical of course), that may help illustrate my point.
Let’s say we buy a $100 invoice. We advance $80 and hold $20 in reserve. So far, our risk is $80. Let’s assume that the expected factoring fee for this invoice will be $2. Easy enough. Now, assume that this invoice is never paid and we are not able to recoup our loss from the client.
We will now need to buy forty $100 invoices successfully (40 invoices x $2 fee = $80) to be able to make up our lost capital. Which means we will need to finance forty invoices before we can get out of the hole and start making a profit again.
I am sure you can see how this situation could get out of hand easily and put us out of business. We compensate for the risk by being very careful, pooling lots of invoices to share the risk, and by charging fees that are commensurate to their potential loss.
The second part of the answer is intrinsically linked to the first. A fixed asset (such as a house), only needs to be audited once, at the start of the transaction. Floating assets need to be audited every day. As a result we bear the burden of very high administration costs.
Therefore higher costs related to funding are the result of higher risks and higher administration costs.