Invoice factoring is a time-tested way to raise cash quickly with little risk. Its origins date back to the 13th and 14th centuries when Jewish merchants began lending money to vendors based on their sales of grain. Today, it’s a multi-billion dollar industry that allows small businesses to leverage their accounts receivable to improve cash flow.
How does invoice factoring work?
Invoice factoring is a financial transaction in which a business sells its accounts receivable to a third party (the factor) in exchange for cash. The receivables are a business asset associated with the debtor’s responsibility to repay the amount due, and act as a form of collateral. When the invoices are paid, the factoring company returns the payment to the business, minus its fee.
Most factoring transactions occur in two installments. After the seller transfers the debt, the factor advances the company a percentage of the total amount due, usually about 70 to 90 percent. Then, when the debtor pays the invoice in full, the factoring company returns the remainder of the money, keeping only the amount of its fee.
What type of business can benefit from invoice factoring?
Invoice factoring is especially useful for B2B sales in which negotiated repayment terms are unfavorable to the seller. It can also be useful in instances where large accounts have defaulted on repayment terms but are expected to pay the amount due.
Say, for example, your business manufactures tractor parts, and your largest customer is responsible for 85 percent of your sales. Because the customer has a great deal of leverage, it negotiates repayment terms of 120 days. This negatively impacts your cash flow, but you’re not in a position to demand a better deal. So you sell the invoices to a factoring partner, who pays you 80 percent of the amount due up front. This solves your liquidity issue and keeps your customer happy at the same time.
Most businesses who use invoice factoring do so on an ongoing basis. This maintains cash flow and also allows the business to negotiate the best fees. Many factoring companies prefer a turnover rate of at least eight times per year and will give favorable rates to companies that meet this goal.
How much are the fees?
Factoring fees vary significantly depending on your industry and the amount of the factoring company’s perceived risk. According to Interstate Capital, there are three main fee structures: flat fee, tiered fees, and administrative fee with interest.
In a flat fee transaction, the factoring company charges a fixed percentage of the total amount of the invoice regardless of how long it takes the customer to pay. So a flat fee of 2 percent on a $1,000 invoice would cost the customer $20, whether the invoice is paid in <30, 30-60, or 60-90 days.
A tiered fee structure ties the amount of the fee to the time it takes the customer to pay. A typical tiered fee might look like this:
- 2 percent of the invoice amount for invoices outstanding between 11-20 days
- 3 percent of the invoice amount for invoices outstanding between 21-30 days
- 4 percent of the invoice amount for invoices outstanding between 31-40 days
- And so on
In this case, a $1,000 invoice paid in 39 days would generate a fee of $40.
Administrative fee plus interest
This fee structure usually involves a low fixed fee (the administrative fee) plus interest (usually a fixed interest rate plus the prime rate.) It’s the most complex fee structure, and it’s the most difficult to calculate in terms of dollars and cents. A typical example is shown below.
- Invoice amount: $1,000
- Administrative fee: 1 percent ($10)
- Amount of advance: $800 (paid in 29 days)
- Fixed interest rate: 3.5 percent per year
- Prime rate: 4 percent per year
- Interest rate: 7.5 percent per year
In this instance, the total amount of the fee would be $14.76: the $10 administrative fee plus the annualized interest of $60 divided by 365 days, or $16.4 cents per day for a total of $4.76.
Getting the best rate can be tricky. Before moving forward with invoice factoring, get proposals from a few companies and calculate the total cost to you.
At the Carmoon Group, our No. 1 goal is helping your business grow. Whether you’re facing liquidity issues or need to better manage your risk, we’re here to help. Give us a call today to set up an appointment to come in and chat. Or reach out using our online form and we’ll get back to you right away.