The advance rate is the percentage of the invoice that a factoring company pays upfront. Typically, it amounts to 75% to 90% of the value of the invoice. Factoring companies then pay the remainder of the balance (or rebate) after collecting the payment from the debtor. Lower advance rates lead to higher costs of capital for small businesses.
How Advance Rates Work
Small business owners that submit an invoice factoring application are evaluated for their creditworthiness and the creditworthiness of their debtors. Based on these two factors and internal data the factoring company has on default rates for different industries, it offers the business an advance rate.
The advance rate can range from 60% to 100%, but 75% to 90% is the most common range based on invoice factoring companies we reviewed. When an invoice is factoring, the lender advances a portion of the invoice and retains the rest as security and to cover any associated fees. The higher the perceived risk of a borrower, the lower the overall advance rate.
After a factoring company collects the payment for an invoice, it deducts its fee and distributes whatever is left to the borrower. While the business ultimately receives the same amount of funding with different advance rates, having access to more capital sooner is preferred. This is why most businesses shop for a low factoring rate and high advance rate when selecting invoice factoring companies.
Advance Rate Example
While calculating the advance rate is simple and only requires one step, it’s valuable to examine the impact on access to capital that different advance rates have. In each case, we assume the business factors $10,000 and pays a 5% factoring fee, or $500, which the lender subtracts from the advance payment. We are examining the advance payment and the payment in three months, assuming it takes 90 days to collect the invoice.
Payment in Three Months
Advance Rate and Credit Risk
Many factors can determine the advance rate a business can expect to get. Among them are the business’s track record in debt collection, its financial standing, and its general history with the factoring company.
One other important factor is the industry the business is in. Naturally, the less stable and risky an industry is, the lower the advance rate a business in that industry can expect to get. Typically, staffing companies and transportation companies get the highest rates of up to 90%. Because of the nature of these industries, disputes don’t often arise, which makes invoices relatively easy for a factor to collect on.
Goods-based companies, on the other hand, are usually given a lower rate, not least because of the greater opportunities for disputes to arise―due to defective merchandise, for example―that might pose problems for the factoring company during payment collection.
The advance rate is the percentage of the invoice that a business receives when factoring an invoice. The rate a business receives from the factoring company is dependent on several factors, including creditworthiness and industry. Small business owners should seek out the highest advance rate available.