Advance, Discount, Reserve – Learn and then name your terms
By Steven Hausman, CEO of Advance Business Capital

Quick review, class. Here’s everything we’ve learned so far:

Factoring is a form of financing suitable for any business that issues invoices paid in 30-90 days.

• Unlike banks, factors are buyers and not lenders. Banks lend you money based on collateral. Factors buy your invoices, but not for the full amount.
• Recourse factoring means if your debtor doesn’t pay your invoice, the factor has legal recourse to get its money back from you.
• Non-recourse factoring means if your debtor doesn’t pay, the factor is stuck with the debt. It has no recourse. For obvious reasons, Non-recourse is more expensive for your company than Recourse.
• Factoring is a three-party transaction. The parties are the seller (you, the carrier), the debtor (the shipper) and the buyer (the factor).

The Three Parts Defined

In our last lesson, we learned factoring involves three parties. It’s also composed of three parts, which make up the transaction between two of those parties: the debt-holder (the carrier, that’s you) and the debt-buyer (the factor).

These parts are (1) the Advance, (2) the Discount and (3) the Reserve. The factoring company decides how much of each one that you get and it keeps. Depending on the factor, these can vary quite a bit. In fact, they can make the difference between a good deal and a not-so-good one, so it’s important that you know what they are and how they’re determined. Bear in mind the deal may be open to negotiation and, if it isn’t, you don’t have to take it.

The Advance
The advance is just what it sounds like. It’s the money the factor advances you on your invoice. As usual, we’re going to use a fictional example to make the abstract concrete.

Definition: the advance is a percentage of the invoice(s) immediately paid to the carrier by the factor.

Hank owns Hank’s Hauling, which is an LTL that specializes in loads between Los Angeles and San Francisco. Hank’s factor is a new name in the game, Firmrate Factoring. Hank wants to factor all of his invoices for this trip, $50,000 worth. Firmrate offers him an advance of $41,000. That’s 82% of the invoice value. Advances typically vary between 80% to 90%, so while Firmrate’s offer is on the low end, it’s not unreasonable.

The Discount
The $9,000 that Firmrate has held back is broken into two parts, the Discount and the Reserve. Let’s deal with the discount first.

Definition: the discount is a percentage of the invoice(s) charged by the factor as its cost of business.

In other words, the discount is Firmrate’s fee, its profit. As with all financing, the percentage varies with the times. If interest rates are high, factoring fees are always slightly higher. If banks start charging less, so do factors, though never lower than the banks.

Straight talk: the terms you get from a factor will never be as good as a bank’s. A bank advances money only on collateral, something real and tangible like gold coins or Savings Bonds or any liquid asset with stable value. Banks hate “paper,” which is slang for invoices or anything that is essentially an I.O.U.

Factors have no trouble with paper. That’s why they’re in business, but since there’s greater risk in advancing funds for money not yet paid, they charge more. Let’s say that if First National is loaning money at 5.5%, Firmrate will be discounting at 8%.

In this case, Firmrate is discounting Hank’s advance by $4,000 (8%). Its discount is its fee. That’s what Hank pays to get most of his money right away.

The Reserve
The rest of the money that Firmrate held back—$5,000—is its reserve.

The reserve is that part of the advance that isn’t immediately paid. All factors hold back reserves. How much depends on lots of things, like the credit rating of the invoice payer, or the trucker’s delivery record (for instance, how many times he’s had damage complaints), or market competition (maybe the factor’s losing business to rivals that hold smaller reserves), and so on. There are lots of things in play when a factor decides on the size of its reserve.

The reserve is your money, not the factor’s. However, in trucking there are always unexpected problems. Maybe the shipper claims you were late with the load and cost them money. Maybe the shipper suddenly goes out of business. Maybe the load gets hijacked and there’s a dispute between insurance companies about liability. For these reasons and others, factors keep part of your funds in reserve.

In theory, you get your reserve back as soon as the shipper pays the invoice, but that too is affected by lots of things. Suppose Hank has five loads for five shippers. One pays in fifteen days, one in 30 days, two in 60 days and one doesn’t pay for 90 days. Unfortunately, the slow-payer also has the biggest invoice: $20,000 for the local distributor of Tortoise Wax. That means Hank won’t get that part of his reserve—$1,000—for three months! But his daughter’s getting braces and the orthodontist doesn’t want to wait for all his money.

Hank’s dealt with the Tortoise Wax distributor before, so he knows what to expect. He can’t make him pay sooner, but he can look for a factor that won’t hold back so much in reserve. He finds it in Crown Factoring, which takes the same discount but has more liberal reserve policies: it only holds back 11% of the invoice value. Hank’s advance is $44,500 ($3,500 more than Firmrate). Sure enough, it takes the Tortoise Wax distributor 90 days to pay and Crown doesn’t release that portion of Hank’s reserve for three months. However, because Hank got a better reserve deal, that portion was only $440, which means he was able to write a $600 check to his daughter’s orthodontist.

There’s one thing which for the sake of simplicity we’ve left out of this formula. Actually, Hank won’t get back the entirety of his $440 because the longer it takes the debtor to pay; the more discount the factor charges. We’ll take that up next class.

Takeaway
There’s the bell! Before you dash out the door, here’s your takeaway.

Every factoring transaction is made up of three parts.

• The advance is the money advanced for your invoice.
• The discount is the percentage charged by the factor, its profit.
• The reserve is the amount held back until all your invoices are paid.

For many truckers factoring is a good deal, but of course not always. Stick with this course and you’ll learn how to tell good deals from bad, and how to make factoring work for you. See you next class!

Advance Business Capital (ABC) provides both Recourse and Non-recourse factoring services for owner-operators, small- to medium-sized trucking companies and factoring brokers. Check us out at www.advancebcap.com