Invoice factoring allows a business to sell outstanding and unpaid invoices in exchange for cash. After approval, an invoice factoring company purchases ownership of the invoice for a large majority of the outstanding amount on the invoice and takes over collection of payment directly from the customer.
The business receives the total amount owed on the invoice, minus a fee called the factoring rate. The factoring company determines the factoring rate based on the volume of invoices and the perceived risk of non-payment. Volume refers to both the number of invoices the business would like to factor, and the amount billed on each.
Businesses owners are also assessed on the size and type of business and their industry, as well as their stability. Using all this information, an invoice factoring company uses an equation to calculate the invoice factoring rate for each business. Naturally, businesses with higher volume and lower risk receive lower invoice factoring rates, and vice versa.
The amount of accounts receivable can substantially impact a company’s finances, making invoice factoring an attractive solution. Some customers even look into reverse factoring as a solution. Unlike regular factoring, where company seeks out an invoice factoring company for financing, the customer initiates the request for reverse factoring.
Before a business can begin factoring their unpaid invoices, they must consult a factoring company to determine their invoice factoring rates. There are two ways to determine factoring rates—flat rates and variable rates.
The most common factoring contract uses variable rates. With variable rates, the factoring company sets a low factoring rate, typically around 1% to 3%, and they’ll increase that rate accordingly if time passes without payment. For example, for the first 10 days that the factoring company owns the invoice, rates may start at 1%, and then increase to 1.5% for 10 more days, and so forth. This encourages a timely repayment with lower factoring rates. The simpler of the two is flat rates. It’s a payment structure that keeps rates the same on each invoice regardless of how quickly customers pay the invoice factoring company.
Flat rates are a preferred option for most small businesses because it reduces the burden of potential high factoring rates when customers don’t pay the factoring company on time. Factoring rates are usually lower for small businesses because they have a lower volume of invoices which makes them a lower risk candidate for flat rates.
One of the drawbacks of using an invoice factoring company is passing on collections to a third party company. The business has no control over how the factoring company pursues payment from customers. When the third party company is aggressive with collections, the impact is often felt by the business as this impacts the customer experience.
A modern day alternative to factoring is a service known as net terms-as-a-service thanks to advancements in fintech. Here’s how it works using a solution like Resolve:
- Credit checks: A business uses Resolve to conduct quiet business credit checks on any customer using its Smart Credit Engine. Unlike a personal credit check, Resolve’s credit check does not impact their credit score in any way. Resolve’s credit assessment uses proprietary financial databases and algorithms to assess each buyer and it able to make credit decisions within one business day. Through its software solution, Resole alerts the business about the customer’s creditworthiness and also recommends how much credit to extend.
- Net terms enrolment: A customer will then be enrolled in net terms (30, 60, or 90 days) via Resolve’s platform. The customer has the duration of their full net terms to make payment on Resolve’s payment portal (branded with the business’s company logo).
- Cash advances: Approved accounts will qualify for Resolve’s Advance Pay. This means up to 90% of an invoice will be paid upfront to the business within a day.
As you can see, the business receives the benefits of a cash flow solution that factoring offers through cash advance payment from Resolve on up to 90% of the invoice. Providing a digital process for net terms also maintains and even elevates customer relationships as this removes the friction they experience from a factoring company.
As an added benefit, Resolve doesn’t just act as an alternative solution to factoring companies. Resolve makes automating your entire B2B accounts receivables process easy by streamlining every essential part of the accounts receivable workflow. They also offer:
- Automated invoice processing and collections: All invoices and reminders are automated and branded with the company logo eliminating the manual time required to chase payments.
- Payment flexibility and versatility: Resolve’s payment portal offers a variety of ways for the customer to pay their invoice (ACH, wire transfer, check, and credit cards) according to their net terms duration.
- Reconciliation: Integrations with accounting systems and eCommerce platforms ensure there is seamless reconciliation between cash received and cash recorded.
Non-recourse factoring is less common than recourse factoring, but it is valuable to know how it works. With non-recourse, the factoring company takes on the burden of non-payment. To compensate for this higher risk, invoice factoring rates are higher.
Typically, non-recourse factoring rates will vary from 2% to 5%. In exchange for the higher rates, non-recourse factoring is relatively risk-free for businesses. There are still some exceptions, and it’s important to read any contract very carefully to understand where the business may still be liable for losses from non-payment.
To qualify for non-recourse factoring, businesses and their customers must have a strong history of timely payment and meet the strict credit requirements of the factoring company.
The invoice factoring cost refers to the amount that businesses pay in fees for invoice factoring services. Most factoring rates fall between 1% and 5%, but it depends on the volume of invoices, discount rates for volume, the amount owed on each, and the perceived risk of non-payment of outstanding invoices.
To find the cost of factoring, a business must determine which rate structure is being used by the factoring company and what the payment terms are. With variable fees, the pricing usually increases with time if payment isn’t made. There may also be hidden costs and fees. It may be helpful to review a factoring company’s BBB rating (and complaints) as well as online reviews. Any reviews that mention hidden fees or unexpected costs may be a red flag.
Some of the most common fees are documentation fees, payment processing fees, or early termination fees. However, a company may not directly list additional fees in the contract.
There are a few things for a business to consider when it comes to variable fee contracts including the number of invoices that will be factored per month, the total invoice value, what industry the business is in, the creditworthiness and credit score of each customer, and the likelihood of the customer sending payment on time.
Businesses that are using flat rates don’t need to consider the creditworthiness of customers and their likelihood of repayment since those factors don’t have any bearing on factoring rates. However, a customer with poor credit or repayment problems may pose other challenges if they don’t pay an invoice that’s been factored. In this case, (unless there’s a non-recourse agreement), the business will have to cover the amount the factoring company paid out with possible penalties added on.
Trucking companies are some of the most regular customers for factoring companies. Most trucking companies receive payments from customers every 30—60 days making it difficult to make ends meet between payments. Considering that truckers need to pay for things like fuel upfront, they may need the type of
Invoice factoring helps trucking businesses keep working capital in their business, and factoring companies who work with trucking companies often have fuel rebates to support them. Due to a higher volume of unpaid invoices than in other industries, trucking companies often look for low factoring rates and high advance rates.
Invoice financing—like invoice factoring, offers immediate cash upfront totaling anywhere from 80% to 95% of the total owed amount on the customer invoice. The difference with invoice financing is businesses use their unpaid invoices as collateral for a loan from lenders, rather than selling an invoice to the factoring company. When the customer pays the business, the business will directly pay off the loan with the factoring company.
The invoice financing option doesn’t require the factoring company to employ a payment collection department because the business is collecting payments directly from its customers. Because businesses take on the burden of non-payment themselves, rates are often lower with invoice financing. Lower risk for the factoring company allows them to offer invoicing with low-interest rates.
A termination fee is a common additional fee that factoring companies charge a customer that ends the contract before the agreed-upon date. Usually, the termination fee is calculated based on the time remaining in the contract, and the factoring rates that the business had at the time of cancellation. The amount owed in a termination fee is calculated in one of two ways.
The first is a calculation of the average rate over the last 90 days, multiplied by the months remaining in the contract. Or it could be written into the contract as a fixed percentage or flat fee that the factoring company has predetermined. If there’s a fixed percentage in a factoring agreement, the amount listed might be inflated to prevent the customer from terminating the contract early.
While invoice factoring can offer a viable solution to cash flow challenges, there’s a great variance in the way factoring companies operate. Before choosing to use invoice factoring, it’s important for a business to carefully investigate the factoring company and know exactly what’s being offered, and at what cost.
Working with factoring companies are a popular solution but businesses must be aware of high and hidden factoring rates. Instead, consider working with a modern alternative like Resolve.
If you’re interested in learning how companies work with Resolve to fuel their business growth and streamline their accounts receivable while eliminating the need for a factoring company, book a demo.