Confused about invoice factoring? Learn exactly what it is and how to calculate its fees and charges.
For businesses providing extended credit terms to customers, invoice factoring can be a valuable source of funding, especially to help make payroll or to take advantage of unexpected business opportunities. But although invoice factoring can prove valuable when you need urgent funding, calculating its costs can be very confusing. This guide will show you how to do it.
What is invoice financing?
If you offer 30- to 60-day payment terms to customers, you may face trouble while waiting for these payments to come through. To circumvent this, factoring companies can advance a large percentage of the invoice, usually between 80-90%, upfront. The remaining amount, minus fees, is made available to you once the customer pays the full invoice.
There are two types of invoice financing: invoice factoring and invoice discounting. For invoice factoring, you’re able to choose which invoices to fund. Invoice discounting, on the other hand, works like a revolving line of funding, where the lender funds an entire batch of invoices at once. The line is modified accordingly as the invoices get paid and as new ones arrive.
Types of invoice factoring
- Single or spot factoring. This can work well for businesses that want to finance a single invoice, or a single batch of invoices, for a one-off application. However, it’s the most expensive option.
- All-of-turnover factoring. This could be an option for businesses in high-growth phases where cash flow is needed on a daily basis. The factoring company funds, at maximum value, between 80-90% of your total ledger amount. Because of the large volume of invoices, this type of factoring has higher rates. Think of all-of-turnover factoring as a line of credit linked to ongoing sales.
- Partial ledger factoring. This allows you to choose which specific customers and invoices to finance to minimise costs, which makes it popular among small businesses. It generally works well for businesses with a large turnover or seasonal fluctuations.
What fees and charges should I expect?
- Due diligence fees. Costs covering credit checks and other work needed to advance funds. These can range from a few hundred to a few thousand dollars.
- Service fee. A one-time fee charged to every invoice you submit for financing. It’s based on the total value of the invoice and ranges anywhere from 0.1% to 20%.
- Discount rate. A percentage rate charged on the advanced funds. It’s calculated daily and charged monthly. Despite the name, this is a fee you'll pay to the invoice factoring company.
How much does invoice financing cost?
Invoice factoring companies make their money through a flat service fee expressed as a percentage of the invoice amount being financed. They also charge due diligence fees to cover the costs of setting up your account, along with discount rates, considered as a compliment to their service fee.
To illustrate, examine the following scenario:
Your invoice amount: $50,000 (to be paid by customer after 30 days)
Advance rate: 80%
Service fee: 2.5%
Discount rate: 10%
Due diligence fee: $400
First, your factoring company would advance you $40,000, which is 80% of the $50,000 invoice amount.
The customer would then pay the invoice in full after 30 days, and the factoring company would rebate $8,021.24 to you, which is the remaining $10,000 that wasn’t initially advanced (20% x $50,000), minus fees.
The fees are calculated as follows:
- The service fee is $50,000 x 2.5% = $1,250
- The discount rate is ($40,000 x 10%) x (30/365 days) = $328.76
- The due diligence fees is $400
The total fee charged would be the sum of these three calculated fees, which is $1,978.76.
If your business needs urgent funding and you’re simply not able to wait for slow-paying invoices, invoice factoring can be a valuable option for you. However, as with all financing, make sure you compare all of your options to find what’s right for you and to avoid getting into too much debt.