What is invoice factoring?
Invoice factoring is a popular financing solution that allows businesses that offer products and services to other organizations to sell their accounts receivable to a third-party company, known as a factor, at a discounted rate and receive a large percentage of those amounts immediately.
The solution is appealing to small businesses because it allows them to leverage their clients’ creditworthiness to fund their growth without cash flow restriction. It benefits larger ones for it allows them to manage cash flow at a predictable cost. And, it may strengthen all businesses when they are able to improve their working capital and empower growth without increasing their debt burden.
Many variables drive the cost of financing when factoring invoices. Two of the core ones are the discount and the advance rates.
- The discount rate is the fee the factor charges for purchasing the receivables. It is typically a percentage of the total value of the invoices sold. The longer the outstanding invoices remain unpaid, the higher the total financing cost will be.
- The advance rate is the percentage of the total amount of the invoices that we will be paid in advance by the factor to the client. The remaining portion is subsequently paid when the factor receives payment from the client’s customers.
Both vary based on several elements, including the client’s credit rating, the client’s ultimate customers’ credit rating, the volume of invoices, the pace at which invoices are typically paid, and the number of customers.
Higher volumes of invoices from numerous highly-rated ultimate customers favorably influence the rates. Conversely, higher concentrations of invoices from fewer ultimate customers or customers operating in industries with higher default rates warrant higher factor rates, lower advance rates, or both, to adjust for the risk.
Definitions and considerations
We describe below some of the cost elements of invoice factoring financing below.
Factoring rate (also discount rate):
Expressed as a percentage and applied to the face value of invoices, it determines the fee charged each time an invoice is factored. For example, if the factoring rate is 1.5% and the invoice factored is $2,000, the factoring fee will be $30. This rate typically covers most of the factoring company’s funding and administration costs.
Rate adjustments, turns, volume, and concentration:
Factoring rates are based on total transaction volume, concentration (number of clients), and timing of payments (turn: how quickly your clients pay factored invoices). Higher transaction volume, faster payments from their customers, and diversification of customers decrease risk. As such, factor rates will tend to reduce over time as these variables improve.
Effect of reserves:
The reserve is the small portion of a factored invoice that is held back until payment for that invoice is received by the factoring company. Larger reserves sometimes result in lower factoring rates, as the factoring company’s risk is lower.
Method of payment fees (ACH, wire transfer, etc.):
Regular ACH payments are the most common. When applicable, fees are typically nominal and vary depending on the lenders. Wire transfers can cost a bit more but provide a quick turnaround.
Added fees:
Some factoring companies may charge other processing fees, including for setup (one-time), chargeback, expedited processing, etc. Such fees are generally listed in the security agreement and must be reviewed before signing.
At BorrowPartner, invoice factoring is a solution we often consider to lower the cost of capital when working with business-to-business clients.
Any questions, please don’t hesitate to contact us. We are always happy to assist.
BorrowPartner provides small businesses with simple, flexible, and affordable access to capital, including small business loans, business lines of credit, and invoice factoring solutions, all customized around your business needs.
