What is invoice factoring?
Invoice factoring is a financing solution that allows businesses selling products or services to other organizations to convert their accounts receivable into immediate capital. Rather than waiting 30, 60, or 90 days for customers to pay, a business sells its invoices to a third-party company, known as a factor, at a discount and receives a large percentage of the invoice value upfront.
The appeal extends across business sizes. For companies with strong customers but uneven cash flow, factoring provides access to capital without adding debt. For larger businesses, it offers a predictable way to manage working capital at a defined cost. In both cases, the financing is driven by the creditworthiness of the business’s customers rather than the business itself, which makes it accessible even when traditional lending options are limited. And because factoring does not add debt to the balance sheet, it can strengthen a business’s financial position while fueling growth.
Many variables drive the cost of financing when factoring invoices. Two of the core ones are the discount and the advance rates.
- The discount rate is the fee the factor charges for purchasing the receivables. It is typically a percentage of the total value of the invoices sold. The longer the outstanding invoices remain unpaid, the higher the total financing cost will be.
- The advance rate is the percentage of the invoice value paid upfront by the factor to the business. The remaining portion is released once the factor collects payment from the business’s customers.
Both vary based on several elements, including the client’s credit rating, the client’s ultimate customers’ credit rating, the volume of invoices, the pace at which invoices are typically paid, and the number of customers.
Higher volumes of invoices from numerous highly-rated ultimate customers favorably influence the rates. Conversely, higher concentrations of invoices from fewer ultimate customers or customers operating in industries with higher default rates warrant higher factor rates, lower advance rates, or both, to adjust for the risk.
Definitions and considerations
The following outlines the primary cost elements of invoice factoring.
Factoring rate (also discount rate):
Expressed as a percentage and applied to the face value of invoices, it determines the fee charged each time an invoice is factored. For example, if the factoring rate is 1.5% and the invoice factored is $2,000, the factoring fee will be $30. This rate typically covers most of the factoring company’s funding and administration costs.
Rate adjustments, turns, volume, and concentration:
Factoring rates are based on total transaction volume, concentration (number of clients), and timing of payments (turn: how quickly clients pay factored invoices). Higher transaction volume, faster payments from their customers, and diversification of customers decrease risk. As such, factor rates will tend to reduce over time as these variables improve.
Effect of reserves:
The reserve is the small portion of a factored invoice that is held back until payment for that invoice is received by the factoring company. Larger reserves sometimes result in lower factoring rates, as the factoring company’s risk is lower.
Method of payment fees (ACH, wire transfer, etc.):
Regular ACH payments are the most common. When applicable, fees are typically nominal and vary depending on the lenders. Wire transfers typically carry a higher fee but settle more quickly.
Added fees:
Some factoring companies may charge other processing fees, including for setup (one-time), chargeback, expedited processing, etc. Such fees are generally listed in the security agreement and must be reviewed before signing.
Invoice factoring is one of several financing tools i95 Capital evaluates when working with business-to-business clients seeking to improve cash flow or reduce the cost of capital. For businesses with strong receivables and creditworthy customers, it can be a compelling alternative to traditional debt.
If you have questions about whether invoice factoring is the right fit for your situation, i95 Capital can help evaluate your options.