- Invoice factoring allows small business owners to “sell” their pending invoices to factoring companies for immediate cash.
- Lenders often discuss two types of invoice factoring rates: the advance rate and the factoring rate.
- Several factors affect your invoice factoring rates like the industry you’re in, your customers’ creditworthiness, your credit score and business stability, invoice volume and value, relationship with the factoring company, factoring period, and type of factoring (recourse or non-recourse).
Having enough working capital is a vital part of running a business. However, companies offering net term payments to their customers can find themselves short on cash from time to time. With most of their capital tied up in invoices, it can be tough to meet their business’ daily needs.
In such instances, business owners will often turn to small business loans for help. There are many funding choices available for small businesses, but one of the more popular options to opt for is invoice factoring. This is especially true for businesses that experience cash flow issues due to unpaid customer invoices.
Before applying for invoice factoring, it’s important to understand what it is and how it works. That’s why we’ve gone ahead and broken it down for you in this article.
Invoice Factoring Basics
Invoice factoring is a form of business financing where companies ‘sell’ their customer’s outstanding invoices or accounts receivables (A/R) to factoring companies (“the factor”). In turn, the business can get the funds they need to sustain their business operation and invest in business opportunities.
One important thing to note about invoice financing is that once the factoring company purchases the accounts receivables, they will have complete control of the entire ledger. This means that the factor will also take control of the payment chasing and collection.
As the factor takes over the company’s accounts receivable ledger, it is highly possible that your clients will be aware that your business is using invoice factoring. While this isn’t necessarily a bad thing, some businesses may be uncomfortable with their customers knowing about their relationship with the factoring company.
As the customer pays their balance, the invoice factoring company will deduct the amount they advanced to you, plus the fees. The remaining balance will then be wired back to your account.
Two Types of Invoice Factoring
Invoice factoring is further distinguished as recourse and non-recourse factoring. The difference between the two lies in who is responsible for the non-payment of the invoices. Here’s a deeper look at how each works:
- Recourse Factoring: Recourse factoring is relatively cheaper and the most common type of invoice factoring. In this arrangement, the factor buys the company’s payment ledger and takes complete control of the invoices. However, in the event of non-payment, the business will be responsible for the invoices. Either they pay the money back using their cash reserves, or they replace the unpaid invoices with another set of accounts receivables with the same value.
- Non-recourse Factoring: In a non-recourse invoice factoring, the factor will take full responsibility for the invoices. If the business’ customer defaults on payment, the factoring company will shoulder the losses. Once the factor pays the business for the accounts receivables, they (the business) won’t have to deal with the invoices again.
Non-recourse factoring is most likely going to cost you more, given the risk the lenders are facing. But you may be able to negotiate the financing’s rate and terms with your lender.
Advance Rates vs. Factoring Rates
When applying for invoice factoring, the lenders may discuss two types of invoice factoring rates: the advance rate and the factoring rate.
Factoring advance rates refer to the amount the invoice factoring company is willing to extend or “advance” to you. Usually, this is expressed as a percentage. In general, the advance rates for invoice factoring can hover between 80% to 95% of the total invoice value.
For example, if the total value of the invoices is $10,000 and the factoring company offers an advance rate of 90%, you’ll receive approximately $9,000 of funding in your account. As for the remaining 10%, the lenders will give the money back once all the customers have paid the invoices. The lenders intentionally hold the difference as this serves as the security for the financing.
When factors talk about factoring rate, they refer to the charge for the invoice factoring service or the interest rate for the financing. This is also the rate at which the factoring company charges the business while the invoices remain unpaid.
The factor rate is calculated based on the total amount of invoices factored and other factors like industry, business, creditworthiness, type of factoring used, etc. In general, invoice factoring rates can range from 2% to 4.5% of the total value of the invoices.
Factors That Can Affect Invoice Factoring and Advance Rates
Although factoring rates are negotiable, it’s still important to know the factors that can affect the rates the factors are willing to offer you. Assessing these factors allows the factoring company to determine the risk they’re facing. From there, they can determine how much factoring rate they can offer to mitigate their risk.
Here’s a look at the criteria that lenders use:
In general, lenders will charge a higher factoring rate to businesses in high-risk industries. This includes construction, travel and hospitality, accounting businesses, and other service-based companies. Conversely, low-risk companies, including businesses that offer goods like wholesale businesses, usually receive lower factoring rates.
High-risk businesses are likely to land lesser advanced rates, while low-risk companies have better chances of getting higher advanced rates.
However, you may be able to negotiate the advance and invoice factoring rates by working with factors that specialize in your industry. Since they have extensive experience in dealing with business owners in your industry, they can tailor the terms in a way that would best serve you and their factoring company’s interests.
Your customer’s creditworthiness will play a part in the determination of your factoring rate. After all, the repayment for the advanced amount will depend on their repayment capabilities.
That said, if you work with customers without an impressive credit standing, lenders are more likely to charge you with higher factor fees – that is, if you get approved for the financing. Essentially, the more creditworthy they are, the lesser risk the lenders face, and the more likely you are to secure invoice financing with a lower factoring rate.
As for the advance fees, the more creditworthy your customers are, the more likely you’ll be able to secure a higher advance rate for your invoice factoring. This is, of course, assuming that you perform well in other aspects (i.e., you’re in a low-risk industry, you have a good business credit score, etc.).
Business’ Credit Score and Stability
Although not as vital as your customer’s credit score, lenders will still consider your company’s credit score and stability when determining your advance and factoring rate. The longer your credit history is, and the more stable your records are, the lesser risk you’ll be in the lender’s eyes. Your stability also shows that you’re working with customers that are consistent with their excellent repayment behaviors. With that, you’ll have higher chances of securing a higher advance rate and lower factoring rate.
Type of Factoring
Recourse factoring and non-recourse factoring poses a different level of risk for the lenders. With recourse factoring, lenders get an assurance that they will be able to regain their losses if the business’ customers don’t pay their invoices.
Non-recourse factoring, however, doesn’t offer the same assurance. Considering the losses the lenders might face, they will be inclined to increase the factoring rate to mitigate their risk. Non-recourse factoring may also offer lower funding amounts, compared to recourse factoring.
Invoice Volume and Value
Businesses that process fewer but high-value invoices are more likely to fare better when it comes to factoring and advance rates than companies selling high-volume, low-value invoices. That is because, with the former, the factoring company doesn’t have to handle a lot of invoices, and therefore, won’t have to put in much effort in collecting payments.
Relationship with the Factoring Company
An existing relationship with the factoring company can also help you qualify for lower rates and higher funding amounts. That is because as you continue selling your invoices to the factor, the financing company will slowly become more familiar with your business and your customers’ repayment behaviors. That said, they will be more inclined to offer better terms for the factoring arrangement.
The factoring period, or the number of days the customers has to pay their invoices, could also play a part in determining the rates your business will be eligible for. In general, the longer the factoring period is, the higher the factoring rates will be.
For instance, if your invoices have a 30-day repayment period, the factors will be willing to offer a factoring rate of 1.5%. A payment of 60 days is more likely to result in a much higher factoring rate.
One of the first things you should understand when applying for any type of financing is the rates. Determine how much the funding will cost your business. You want to make sure it will actually help your business achieve its potential rather than leave you knee-deep in debt.
If you’re planning to apply for invoice financing, we hope this article can serve as a helpful guide to getting started. Know that you can always negotiate with your lender when it comes to invoice factoring rates. While the factors mentioned play a role in determining your advance and factor fee, the final figure will ultimately depend on what you and your lender agree to in the end.