Factoring Company or Early Payment Discounts
Why would a business use a factoring company? Why would they offer early payment discounts? The answer to both of these questions is often one in the same…the need for working capital. So what is working capital and why is it so important that a business would consider using these methods to make sure they have it? According to this recent working capital article, Will Gish states:
“Two basic definitions exist for working capital. The more technical of the two explains working capital as the difference between all short-term assets and short-term liabilities. The simpler definition describes working capital as the cash available for the day-to-day operations as a business.”
In laymen terms, working capital is the life blood of a business. Insufficient working capital means that a business does not have enough cash available to meet its current obligations. So how do invoice factoring companies and early payment discounts help? They are both working capital management tools that can be used to quickly convert accounts receivable into cash. While they both accomplish the same objective, there are some key differences that will often make one more desirable than the other.
Using a Factoring Company
The primary advantage to using a factoring company is that you get to decide which invoices to factor and when to factor them. What this really means is that you control the timing and amount of your cash inflows. The reason this is so important is because it puts you in the drivers seat as opposed to early payment discounts which put your customers in control. The problem with your customer deciding when and if they will pay early is that their needs are not your needs, and as a result, they are likely to pay you early when you don’t need the working capital and take their time paying invoices when you’d rather them pay immediately. In many ways, especially if the early payment discount rate is equivalent to the factoring company fee, factoring can be thought of as an early payment discount with one major difference…you control who takes the discount and when they take it!
Offering Early Payment Discounts
So if using a factoring company is basically like offering early payment discounts to your customers, except you get to control it, why would anyone ever offer early payment discounts? The primary reason to consider using early payment discounts is cost. If you have a customer that is willing to regularly pay early, and the discount you offer “costs” less than factoring would, you’d be smart to consider using early payment discounts. The problem that can arise when offering early payment discounts is this…what happens when you no longer need them to pay early, but they still do to take advantage of the discount? As you can see, while offering an early payment discount may at times “cost” less in the short term, since you don’t ultimately control when it is taken, it can end up costing much more than using a factoring company does in the long run.
Final Thoughts
Clearly, there is a place and time for both working capital management tools. That being said, factoring provides a certain amount of control and flexibility that is often not found in other forms of financing, including the offering early payment discounts to your customers. Our suggestion is to compare the benefits of both to determine if your working capital needs can be served by one, or a combination of both. In our experience, most business have benefited from using a factoring company even if only used to supplement their early payment discount program. If you’d like to learn more about how we can help or whether factoring is right for your business, feel free to contact us now.