Invoice factoringcanimprovecash flowandfree up time and resources.
Many different kinds of businesses use it. But because they are different, so too are theirinvoicefactoring fees.
To determine ifinvoice factoringisthe right solutionfor your company, andhow much it will cost, you should consider it in the context of yourindustryand specific business situation.
A first step toward this is understanding howinvoice factoring costsare calculated.This article will help you with that.
But first, let’s look briefly at some background information.
How invoice factoring companies work
Invoice factoring companiesspecializein processing invoices on behalf of other companies. They can be stand-alone companies or subsidiaries of other entities in thefinancialindustry.
Invoice factoringisnot to be confused with another kind ofinvoice finance: invoice discounting.The latter is when a company puts up its existing invoices as security for whatalmostamounts to abank loan.
The main difference betweenthe twois that the former includes business services other than just lending capital. This meansinvoice factoringis usually a more expensive – but more comprehensive – service thaninvoice discounting.
It’s one of a number of financing options available to businesses.
Notification vs non-notification factoring
Buyers (i.e., those paying the invoice) may or may not realizethey are dealing with a third-partyinvoice factoring company.
This depends on whether their provider is using anotification(when buyers know that a third party is processing the invoice) ornon-notification factoringfacility(when they don’t know).
Mostfactoring companiesprovide notification factoring. Setting up non-notification factoring takes more work but qualifying for it usually requires more stringent criteria, which itself may bring down costs.
Recourse vsnon-recourse factoring
Mostfactoring companiesoffer arecourse factoringservice. This means that if the buyer doesn’t pay some or all of the invoice, the provider (not thefactoring company) must cover the costs.
Non-recourse factoringis when thefactoring companyundertakes liability for each invoice. Because of the obvious risk, this type offactoring costsmore andqualifying for itrequiresabetter creditrating.
Is invoice factoring right for your company?
There are different kinds ofinvoice finance. Whetherinvoice factoringin particular iscost–effectivefor you usually depends on whether you need to improvecash flowin order to maintain or increaseturnover.
You canuse aninvoice factoring facilitywith only somehigher valueaccounts or for a shortperiodof time. Perhaps, for example, sudden growth has temporarily overwhelmedyouraccounting facilities that were set up to process a lowervolume of invoices.
Invoice factoring costswould be a wasted expenseif youdon’t needyourinvoices paid immediately – after all, it does reduce the total amount of invoice value thatyoureceive.
The basic components ofinvoice factoring costs
There are two basic parts toinvoice factoring fees:
- Thediscount fee+the service fee
For both of these, there are averagebase ratecost ranges withininvoice factoringgenerally. However, this range on its own isn’t very instructive because fees usually depend on multiple factors (see below).
Let’s look closer at these two main components oftypical fees.
Discount fee
The discount fee (sometimes known as thediscount rateor factor rate) is the fee thefactoring companycharges for factoring an invoice.
It iscalculated as a percentage of the invoice valueand usually ranges from between1.5 – 5%.The discount rate only applies to the funds advanced.It is often calculated as an annual rate then charged on aweekly or monthly basis.
For example, if it was 5% of your totalinvoice value, and you usedinvoice factoringfor a single $100,000 invoice with a 30-day term each year, you would pay$410.95 ((5,000 ÷ 365) x 30).
It can basically be considered an interest rate on the advance provided by theinvoice factoring company.
Service fee
Aservice feeis essentially an administration fee that factoringproviderscharge for a range of services around processing and managing invoices.
It usually lies in therange from0.5– 2.5%of the value of invoices factored. As with thediscount chargeabove, its precise figure depends on multiple factors.
Sixvariables that influence factoring costs
The specific rate of the factoring and service fees depends on multiple variables. Many – but not all – of them are out ofyourdirect control and some may vary depending on the factoring supplier.
Below is a list of some of the keyvariablesto consider.
1. Size andvolumeof transactions
Thesize of each invoiceand theirvolumewill significantly influence your factoring fee.
Ifyou areable to guarantee a highvolume of invoices, afactoring companywill likely offer lowerfactoring fees.
Conversely, it is in your interest to have your invoices factored less frequently because this reduces thecost of factoring. I.e., processing one $20,000 invoice costs less than processing two $10,000 invoices, which costs less than processing four$5,000 invoices, etc.
In short, to keep costs down,it is inyourinterest to have larger invoices factored less often.
2.Industry
Certain industrieshave a higher risk factor than others. Thereare multiple ways to measure risk, but generally speaking, there is a consensus on which industries have the highest risk.
Industries such as retail, agriculture and even accounting, for example, are seen as relatively high risk. Gambling and alcohol even more so. Whereas others, such as scientific research, laboratory wholesalers, andeven flying schools, are seen as low risk.
Thecost of factoringwill reflect eachindustry. One wayyoucan potentially reduce this factor is to look forinvoice factoring companiesthat specialize inyourindustry.
One example for this is factoring for the freight broker industry. Freight carriers may need this service because of the difference in terms between shippers and carriers.
3.Providers‘ credit history
One of thekey factorsfor afactoring companydeciding rates (or evenfee structure) is the state ofyourexistingcredit management.
Thefactoring company maycarry outcredit checks(see below) early on to determineyourfinancialhealth.Bad debtsand poor credit over a longperiodwill increase the risk to them. The factoring fee they offer will reflect this.
4.Providers‘ customers
The payments and punctualitytrack recordofyourcustomers will also influenceinvoice factoring fees.
Ifyouhavea backlog of outstanding invoices from customers, aninvoice factoring companywill sense a high degree of risk from working withyou. This could lead them to quote higher rates (in order to cover theircredit protection) or even declining to work withyou.
Thediscount chargethat thefactoring company mayquote will reflect their perception of risk of late payment or defaulting fromyourcustomers.
5. Customers’ payment terms
Most invoices havepaymenttermsof30 days. Ifyourbusiness has previously agreed to a longerperiod(60 or even 90 days, for example) thenfactoring chargeswill often be higher.
Thefactoring company maysimply charge the samediscount chargeover thisperiod. This is because the longer it takes for them to receive payment, the more risk they are exposed to.
6. Relationship withfactoring company
As with businesses everywhere, relationships in theinvoice financeindustryare important. This is because trust is a particularly important factor in the processes involved.
Over time,yourcompany can develop a relationship with aninvoice factoringprovider that may also lead to a betterfinancialunderstanding, resulting in a lowerbase ratefor the service ordiscount rate.
This could be based onyourgeneral reliability, business growth potential or positive market developments.
4other possiblefactoring charges
Below is a list of potentialadditional coststhat might come withinvoice factoring.
1. Signup fees
Some factoringprovidersmay charge some form of a sign-up fee (sometimes referred to asa set-up fee, origination feeorapplication fee).
This isn’t a part of everycompany’sfee structurebut it is worth remembering whenseekinga provider. In some cases, especiallyif your company hasan excellentcredit historyand highturnover, it can be waived.
2. Credit check fees
Credit checksare a necessary part of the process forfactoring companies.
Releasing the cashfor invoices (especiallyhigh-value invoices) thatgo unpaidcould disrupt afactoring company’s owncashflow – an essential part of its business.
A factoring provider will look atyourkey finance figures, such asturnoverand profitability, to calculate what ratestooffer.
3. Late payment fees
The likelihood of latepaymentofinvoice varies for every business, depending on itsindustryand customers. Late payments will disrupt the factoring process and may come at a costyou(unlessyouare using a non-recourse factoring provider).
4. Contract termination fees
Somefactoring companiesmay include a termination fee clause in their contract.
To avoidthese fees,youshould thinkcarefully about how longyouneedafactoring facilitybefore signing a contract.
Youshould consider whetheryourissue withcashliquidity is ongoing or temporary and whether thevolume of invoicesyouneed factoring justifythecost of factoring.
Conclusion
Invoice factoringis an efficient andpopulartype ofinvoice finance. It works well for companies thatneedtoquicklyimprovecash flow.
Invoicefactoring costsarelikely to becheaper than abank loanand comes with a useful invoice processing service.
The basicfee structureis usually similar betweenproviders.
However,the specificfactoring chargesdepend on which type ofinvoice factoring(notificationornon-notification,recourseornon-recourse) are used.
Generally speaking, high-value invoices and a largerturnoverbrings lower fees.
While factoring fees can vary widely, you should now be able to anticipate how your business will be evaluated by service providers.
