What is Invoice Factoring?
Invoice factoring (debt factoring or accounts receivables factoring ) is a financial agreement in which a business sells its invoices (also called account receivables) to a factoring company at a discount. With invoice factoring, a business gets access to immediate cash flow instead of waiting for months for the invoices to get paid.
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Cost of Invoice Factoring
These two major factors determine the cost of invoice factoring.
1. Factoring fees
Also called a discount rate or factor rate, this fee is the cost of the factoring services provided by the factoring company. The factoring fee is calculated as a percentage of the total costs of all the account receivables. Factoring fees can vary from 3–8% of the overall value of the unpaid bills.
This factoring fee can be charged weekly, monthly, or annually, depending on the conditions of your agreement.
2. Upfront cash value
Relationship Between Advance Rate and Factoring Fee
There is no direct relationship between these two. You might be thinking that if a factoring company offers a higher advance rate, will they charge a higher fee too? The answer is yes and no.
- A factoring company that offers a high advance rate is taking on more risk. If the client fails to pay the pending bill, the factoring company will be at a disadvantage because they have already paid out a significant portion of that invoice to you. To account for this increased risk, they might charge higher factoring fees. However, this isn’t a rule.
- The factoring market is competitive, and fees are influenced by what other factoring companies are offering. Some companies might offer higher advance rates without higher fees to remain appealing to businesses.
- Factor fees and advance rates are affected by many other factors, which we’ll talk about in detail further.
Invoice Factoring Cost Example
Let’s consider an example of invoice factoring. Make sure you understand advance and factor rates before we talk about what other factors affect the cost of invoice factoring.
Imagine you’ve issued an invoice for £10,000 payable in 30 days but need cash sooner. You opt for invoice factoring, where a factoring company offers a 90% advance rate and a 5% factoring fee. You receive £9,000 upfront (90% of the invoice). When your client pays the full invoice amount (£10,000) to the factoring company, they deduct a 5% fee (£500), and you receive the remaining balance of £500 at the end.
Factors Affecting the Cost of Invoice Factoring
Factoring companies consider the strength of your invoices before getting into an agreement. There are a lot of factors to consider when evaluating your invoices.
Reputation of your business sector
Different types of businesses have different client bases and reputations, which can affect both the advance rates and the factoring fees. For example, healthcare or pharmaceutical industries in the UK, which are known for stable and reliable payments, might enjoy higher upfront cash and lower factoring fees.
On the other hand, businesses related to the construction sector in the UK can get very different rates. In this sector, invoices involve multiple clients with long-term contracts. There can also be disputes over project completion among different parties, and late payments are also more common.
History of your clients and how reliable they are
Factoring companies prefer low stakes. If your business has a good relationship with your clients, there is a high probability that they’ll pay the pending bills on time; hence, your factoring company will see it as less risky. If your business has trustworthy regular clients with a good credit history, then you are most likely to get lower rates for factoring and a large portion of your invoice value upfront.
Fixed minimum sales and amount of invoices
The amount of business you bring to the factoring company matters. If you have a high volume of invoices, you can get better rates. Some factoring companies also require businesses to have a fixed minimum of sales. This is to make sure the business is in a healthy financial state.
Length of contracts with your clients
The factoring fee increases with the length of the factoring period—that is, the time from when you factor your invoice until your customer pays it in full. If your customer pays the invoice within 30 days, you’ll face a lower factoring fee compared to a scenario where the customer takes 90 days to settle the amount. This reflects the increased risk and financing costs for the factoring company over longer periods.
But what makes businesses choose invoice factoring? It’s not just about the costs; many companies use it to manage their cash flow and keep up with the payment cycles. To better understand why invoice factoring is so popular among different industries, check out the video below.
Additional Invoice Factoring Costs
Keep in mind that these invoices are not always explicitly mentioned in your contract with the factoring company. We advise that you carefully read the conditions of your agreement. It’s always better to ask any questions beforehand to avoid surprises later.
Late invoice fee
A factoring company would want to minimise its financial stake. If a customer fails to pay the pending money for an invoice on time, the factoring company can try to charge you an overdue or penalty fee.
That’s why it is advised to read your factoring agreement carefully and see if there is anything mentioned related to it. Even if there’s nothing explicitly mentioned, ask your factoring company about their strategy if a client doesn’t pay on time.
Collection services charges
A factoring company uses its resources to collect payments from your clients, which is usually covered by the factoring fee. However, some factoring companies can charge you separately for their management and execution.
This is beneficial for small businesses because it saves them from having to chase after payments themselves, instead, they can pay a small amount to the factoring company to collect their invoices.
Annual fee
This is not a common fee, but it can be applicable in some cases. If you have worked with a factoring company for more than a year, they might charge you an annual fee or a fee to renew your factoring contract.
Penalty for early cancellation of the agreement
If you discover a provider offering to purchase your invoices at more favorable rates, or if you decide to go in a different direction, you should have the flexibility to terminate your contract at any point. Some factoring companies try to trap businesses in long-term contracts with a penalty if you cancel the contract before it ends.
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FAQs
Factoring fees are usually charged as a percentage of your total invoice value (3% to 8%). This fee is also called a discount rate.
The advance rate is the percentage of your invoice that the factoring company gives you at once. This typically ranges from 70% to 90%. The advance rate depends on factors such as your business type, the creditworthiness of your customers, and your company’s history.
Yes, factoring fees can sometimes be negotiable. The factoring fees depend on your business’s financial health, your client’s payment history, and the number of invoices you’ll factor. It’s best to always compare offers from different factoring companies before making a decision.
Yes, there can be additional costs like late invoice fees, collection service charges, and annual fees. Some factoring companies also charge a fee if you cancel the contract before the agreement ends. It’s important to read the agreement thoroughly and ask the factoring company about any potential hidden fees before signing.
