Unfortunately, piling outstanding customer invoices is a reality among many companies in the service-based companies. As a result, cash flow becomes stagnant, making it harder for businesses to keep up with their financial obligations. To free up cash flow, companies often resort to invoice factoring.
Invoice factoring is a form of invoice financing that allows businesses to advance the cash tied up in unpaid customer invoices, so they won’t have to wait a few weeks or months for their clients to settle their balances. It accelerates cash flow so the businesses can pay their obligations on time and take advantage of time-sensitive business opportunities.
As with other financing options, understanding the factoring rates is key to maximizing the benefits of the financial resource. We’ll discuss the invoice factoring rates below.
Recap: How Does Invoice Factoring Work?
Invoice factoring allows businesses to ‘sell’ their customer’s outstanding invoices to a factoring company, called a factor. The factor buys the invoices at a discount – usually around 80% to 90% of the total invoice value. The business then gets a lump sum upfront, and they can use the proceeds to address any financial obligations.
With invoice factoring, the factor will have complete control over the accounts receivable ledger. This also means they will be responsible for the payment chasing and collection. While this can be beneficial, especially if you don’t have enough resources, it could also be a deal-breaker for some because the customers will be aware that you’re using invoice factoring.
Once the customers settle their balances, the factor will deduct the money they advanced, plus a small fee. Whatever remains of the money will then be transferred back to you.
Recourse vs. Non-recourse Factoring
Lenders may offer two types of invoice factoring: recourse and non-recourse factoring. The main difference between the two lies in who is responsible for the invoices if the customer defaults. Here’s a quick look at each type.
With recourse factoring, the business will be responsible for the unpaid invoices if their customers default. Lenders will typically give you a few choices on how to make up for the losses: (1) you can exchange the invoice with another one of the same value, or; (2) you can pay the invoices yourself using your cash reserves. With recourse factoring, the borrowing business will assume 100% of the responsibility.
In non-recourse factoring, the lender or factor will assume full responsibility for the invoices, whether paid or unpaid. This means that if the customer defaults on the payments, the factor will shoulder all the losses. Since the lenders take on most of the risk, non-recourse factoring is usually more expensive.
What are the Typical Factoring Rates?
As the lenders discuss invoice factoring with you, they may talk about two types of rates: the advance and factor rates. We’ll discuss what each of them means below.
When you sell your invoices to a factor, one of the things they will talk about is the advance rate. Advance rates refer to the amount you’ll receive upfront. It’s usually expressed as a percentage of the total value of the invoices. The factors can fund anywhere between 80% to 90% of the total value of the invoices. The lenders will hold the remainder until the customers pay their balances.
Here’s an example. Suppose your invoice value is $100,000. The factor approves your application and agrees to give you an advance rate of 85%. In this case, you will be receiving $85,000. The lender will hold the remaining 15% or $15,000 until your customers settle their invoices.
Advance rates vary by industry. High-risk industries such as construction, restaurant, medical, and other service-based companies typically have lower advance rates. On the other hand, the trucking industry has been considered one of the safest clients. Therefore, they usually get higher advance rates than other businesses.
Factoring rates are the interest rates of invoice factoring, or the percentage the lenders will charge for every day or week your customer’s invoices remain outstanding. Depending on the lender, it could be anywhere between 2% to 4.5% of the total value of the invoices.
Using the example above, if the factor approves you for 85% and the factoring fee is 2.5%, you’ll have to pay $2,125. Usually, the amount will be deducted from the remaining 15% that the lender held on to.
Lenders may also charge a flat rate or variable rate. A flat rate means you will pay the agreed-upon rate, regardless of how long the customer settles their invoices. On the other hand, if the lender charges a variable rate, the factoring rate will depend on how long it takes your customers to pay their invoices. Essentially, the longer the invoices remain outstanding, the higher your costs will be.
What Factors Affect Your Invoice Factoring Rates?
1. The creditworthiness of the business’ customer
Since the repayment of the advanced amount will depend on their repayment capabilities, lenders will naturally be concerned about their creditworthiness. As a business owner, it’s crucial to ensure that your clients have good credit standing. Otherwise, the factors may deny your application, or if they do agree to factor your invoices, you’d most likely be charged a higher factoring fee.
The same thing goes for advance rates. If you work with less credible customers, the factoring company is less likely to approve you of a higher advanced rate.
2. Invoice volume and value
Businesses that factor a few but high-value invoices are more likely to get better advance rates and factoring rates than companies that factor high volume but low-value invoices. That is because factors won’t have to put in much work in servicing a few high-value invoices. With the latter, factors would have to handle a lot of invoices which means they will have to chase and collect payments from several customers.
The type of industry will also affect the advance and factoring rates since some industries are riskier than others. For instance, staffing, construction, and hospitality companies may get lower advanced rates than trucking industries because of seasonality.
The good news is that there is a quick fix to this. Some invoice factoring companies specialize in factoring invoices from high-risk industries. Businesses may be able to negotiate higher advance rates and lower factoring rates under the right conditions (stellar customer credit scores, solid financial background, and good business credit score).
4. Factoring type
Lenders carry more risk with non-recourse factoring since they will shoulder the losses if the customers default on the invoices. Lenders are likely to approve lower advance rates and higher factoring rates to mitigate the risk.
Recourse factoring, by definition, carries less risk for the lenders. In case of a default, the factoring company is assured that they will still get the money back. Naturally, recourse factoring usually has higher advance rates and lower factoring rates.
5. Business’ creditworthiness and history
Though not a major consideration, your business’ credit standing will also affect how much your advance rate and factoring rates will be. Generally, lenders prefer working with companies with a longer credit background, especially if they show a consistent, stellar track record. For the lenders, these businesses are less risky, so they’re considered ideal customers.
Plus, if you’ve been in the business for long enough, the lenders will think that you’re working with creditworthy customers. That said, you’ll have better chances of getting favorable invoice factoring rates.
6. Invoice net terms
Invoice net terms refer to the payment period for the invoices. Depending on the company, it could be 30 days or more. Essentially, the longer the invoice net terms are, the higher the factoring rates will be.
7. Relationship with the factoring company
An existing relationship with the factoring company increases your likelihood of getting higher advance rates and lower factoring rates. This is especially true if you have a good track record of customer payments. Since the factoring company is already aware of your repayment behaviors, they will be more confident in offering better terms for the factoring agreement.
Invoice Factoring Rates: The Bottom Line
Invoice factoring can be a helpful financial resource if utilized responsibly. By responsibly, we mean fully understanding what the financing is for, how it can help your business, and the costs that come with the funding.
Before applying for invoice factoring, make sure to consider the rates first. Ask yourself these questions before fully committing:
- Are unpaid invoices affecting my cash flow?
- How much will the financing cost me?
- Can I afford the repayments?
It’s also worth noting that there may be other fees that the factors will charge. It may include application fees, closing fees, termination fees, etc.
Finally, before signing the factoring agreement, review the terms first. If possible, have your accountant or business lawyer walk you through it. This way, you’ll be able to understand what you’ll be in for if you decide to pursue invoice factoring for your business.