Debt factoring can be a smart way to improve the cash flow of a business. The process works in a way where a business receives instant cash funds in exchange for selling its unpaid invoices to a factoring company. But like any other invoicing solution, debt factoring is not free. The factoring company charges a fee in exchange for the service.
In this guide, we’ll break down what a business actually has to pay for debt factoring. We will also explain the factors that affect the total costs, how to keep those fees in check, how to choose the right debt factoring company and discuss some tips that will save your money.
What is debt factoring?
In a debt factoring agreement, the two participants, the factoring company and the business, are involved. The process is also called invoice factoring and is initiated by the business when it decides to sell the unpaid invoices in exchange for advance cash. It is useful for businesses that can receive 70% – 90% of the advance amount of the total invoice value instead of waiting for clients to pay on their own. This helps them cover any immediate expenses and resolve the disrupted cash flow.
Compare Invoice Financing Quotes Today
How does debt factoring work?
The ownership of the factored invoices mostly gets transferred to the factoring company in the case of debt factoring. We can explain the process in the following steps:
- The business starts by choosing the invoices to factor. The selection criteria are different for each business, but usually high-value invoices are selected that span over a payment term of 30-90 days.
- The business then sends these invoices to the factoring company.
- The factoring company evaluates them to decide whether the business qualifies for the service. At this step, the advance amount and the factor rate are also calculated for the specific business.
- Once decided, the factoring company transfers a percentage of the total invoice value to the business and continues to collect payments directly from clients.
- Once all the invoices get cleared, the factoring company transfers the remaining amount to the business minus its fees.
Primary costs of debt factoring
The main debt factoring costs include the advance rate and the discount rate. These two figures directly affect how much money you’ll receive and how much you’ll pay.
Advance rate
This is the percentage of the invoice value you’ll receive upfront. It is usually between 70% and 90% of the factored invoices. The exact amount of the advance depends on multiple factors that we’ll discuss later in the blog.
Discount rate
The discount rate is the factoring company’s service fee. It is charged as a percentage of the invoice total and usually ranges from 1% to 5%. The factoring company automatically deducts it before sending the full invoice value to the business.
Example of debt factoring
Let’s consider an example of a small company that has issued an invoice of £50,000 to a client, and the payment is due in 60 days. Then, the company decides to debt factor the invoice under the following conditions:
85% advance payment and 2% factoring fee.
Advance payment = 85% of £50,000 = £42,500
Money left with the factoring company = £7500
Discount rate = 2% of £50,000 = £1000
So, the final amount paid by the factoring company after collecting all the payments is (the money left with the factoring company) – (discount rate) = £7500 – £1000 = £6500 + £42,500 = £49,000.
Additional costs of debt factoring
Other than the basic factoring fee, there are many other charges to watch for in a debt factoring agreement.
1. Advance transfer fee
This fee covers the cost of transferring money into the business’s account. It’s usually small and gets absorbed in the administration fee for one-time users. But it can add up for businesses with multiple debt factoring agreements and frequent use.
2. Invoice processing fee
It’s a charge for every invoice the factoring company handles. It should be taken into consideration if a business sends many invoices.
3. Administrative fee
An administrative fee is a flat monthly or one-time charge for managing the payments from the business. It covers the operational costs to manage the payment collection process, sending payment reminders to the clients and following up with them.
4. Dispute resolution fee
If a customer disputes an invoice, the factoring company may charge for handling the issue.
5. Contract-related fees (termination and renewal)
Some providers charge fees if the business ends the contract early. Similarly, they can also charge a contract renewal fee if a business renews the contract after a set term.
6. Penalty fees
These are charged if a client pays late or if a business breaks certain terms of the agreement. The key to preventing any penalty fee is to read the contract carefully and understand the terms.
How are the debt factoring costs determined?
Factoring costs aren’t based on your business’s credit like a traditional loan. Instead, they depend mainly on the creditworthiness of your clients and how much risk the factoring company takes on. Let us break down both of these ideas.
Risk-based (recourse or non-recourse)
| Feature | Recourse Factoring | Non-Recourse Factoring |
|---|---|---|
|
Who takes on the risk? |
Your business |
Factoring company |
|
Typical fees |
Lower |
Higher |
|
What if the client doesn’t pay? |
You repay the factoring company |
The factoring company absorbs the loss (conditions apply) |
|
Best for |
Businesses with reliable clients |
Businesses wanting payment protection |
The factoring fees of a debt factoring agreement depend on whether it is recourse or non-recourse.
- In a recourse agreement, if a customer does not pay the invoice, the business is liable for the loss. This reduces risk for the factoring company and usually results in lower fees.
- In a non-recourse agreement, the factoring company takes on the risk of non-payment. Because they’re accepting more uncertainty, they charge higher fees to cover any potential losses.
Clients creditworthiness
The factoring company gets repaid by the business’s customers, and their ability to pay matters the most in this case. If a business’s clients have strong credit histories and pay invoices on time, it is considered low-risk. This increases the possibility of a high advance rate and a low factoring fee.
Factors that influence debt factoring costs
We have already mentioned the two major factors that influence the debt factoring costs, but that’s not all. Let us look at other conditions that decide the percentage of advance and discount rate for a business.
1. Business industry
Some business industries are riskier than others. This risk is measured by whether a business sector has lengthy payment terms, frequent late payments, and a high possibility for payment disputes. The factoring company decides the discount rate considering the industry standards of a specific business.
2. Invoice sizes or volume
High-value or a high number of factored invoices determine the total factoring fee and the advance rate for a business. They also increase the contract term of the agreement and boost the factoring company’s earnings.
3. Payment duration
For invoices with lengthy payment durations, the factoring company has to manage the administrative tasks for longer, which in turn increases the total cost of the service.
4. How old or new the invoices are
Factoring companies prefer to factor fresh invoices, not older than 20 days. That is because recent invoices indicate a high possibility of getting paid on time. On the other hand, if an invoice is already 40 days late, the factoring company assumes a higher risk of non-payment with it.
How to save on debt factoring costs?
By following a few smart steps, your business can save on debt factoring costs without missing out on its benefits.
- Choose the right factoring company: Rates, services and contract terms vary a lot with providers in the UK. When choosing a factoring company, take your time comparing its specifics with other providers in the industry.
- Work with creditworthy clients: Even before getting into a debt factoring agreement, encourage your clients to clear the payments on time. The higher the creditworthiness of the clients, the lower your fees.
- Invoice high-value and recent invoices: Focus on sending in recent and high-value ones where possible.
- Opt for recourse factoring: Choosing recourse factoring will significantly reduce the overall costs for your debt factoring agreement.
- Factor invoices only when needed: Use the service smartly, only when the cash flow is tight or urgent expenses need to be covered. It should be a temporary solution to regulate the business’s finances, not a sought-after one.
- Read the contract terms carefully: Before finalising the debt factoring agreement, make sure that you have understood the cost breakdown, fee structure, the factoring company’s policies and the contract terms.
Questions to ask before choosing a debt factoring provider
We have compiled a list of 5 questions that you can ask yourself before choosing a debt factoring provider:
1. How many years of experience does the factoring company have?
If a factoring company has been operating for a long time, it indicates that they have been consistent in their services and have increased their reliability.
2. What is the advance rate offered by the factoring company?
The advance rate offered by the factoring company should match your financial needs. The higher the advance rate, the more cash you’ll receive.
3. What are the terms of the contract?
This question is important because you wouldn’t want to be stuck in a long-term contract without even knowing it. Make sure that you understand the terms and conditions of the agreement, including the fine print and any additional details.
4. Does the factoring company require a minimum volume of invoices?
Some factoring companies demand a minimum number of factored invoices. For small businesses with a limited number of clients, this can become a problem.
5. How does the factoring company deal with customers?
Consider looking into the reviews of the factoring company from their previous clients. This will help you understand how it communicates with your clients. A factoring company should practice professional standards to maintain a good image of your business.
ComparedBusiness UK provides you with top options for debt factoring
We at ComparedBusiness UK are experts in saving your time and money. Just submit your requirements in less than 2 minutes, and we will get back to you with quotes from a list of top debt factoring providers. You can pick and choose the best option for your business.
FAQs
Yes, you can negotiate factoring fees with the factoring company in most cases. Especially if you have a good volume of invoices or reliable customers. In any case, it’s always worth asking for a breakdown of charges to see if there is room for adjustment.
After submitting an invoice, a business can receive the funds in as little as 24-48 hours. The exact funding speed depends on the specific factoring company you work with.
It depends on the type of factoring. In recourse factoring, the business will need to repay the factoring company in case a customer defaults. However, in non-recourse factoring, the factoring company takes the responsibility for non-payment. This is only applicable if the customer defaults. In other cases, like an invoice dispute or delay, the contract terms can be different.
