Factoring companies provide capital as a relative portion of the invoice value. The portion they advance right away is called the advance rate and usually ranges from 75% to 95% of the invoice value. Advance rates typically vary based on the industry, due date, volume, and debtor’s credit in a factoring transaction. Small business owners should prefer a larger advance rate when selecting an invoice factoring provider.
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.
How Factoring Advance Rates Affect Costs
Small business owners should include the advance rate, which they can negotiate, when considering the overall cost of factoring. With a lower advance rate, the business effectively is getting access to less capital and, therefore, incurring a higher cost to get access to funding. As a business owner, your financial preference should always be to invest capital in the company sooner, rather than wait for an uncertain future.
How Factoring Companies Determine Advance Rates
The amount of risk the factoring company carries is the primary consideration when setting advance rates. In most cases, the riskier the invoice, the lower the advance rate, and vice versa. Small business owners can increase advance rates by factoring invoices with shorter terms and creditworthy debtors.
Other characteristics that may affect the advance rate include:
- Industry: The less risky and more predictable an industry is, the more likely it is to have a high advance rate. For example, inventory invoices have a lower advance rate than medical invoices.
- Due date: Invoices that are due sooner present less risk to the factoring company that, in turn, allows it to offer a larger advance rate.
- Volume: Companies that factor a large volume of invoices typically have more leverage in negotiating with factoring companies and can receive a higher advance rate on invoices.
- Debtor credit: Debtors that have exceptional credit, for example, major companies like Amazon and Walmart, represent less risk to a factoring company, which increases advance rates.
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.
Advance Rate Case Study
Receiving a lower advance rate is acceptable to most business owners, but it may have a significant impact on cash flow as the business scales. The delay in receiving a large part of the invoice means that the business has less capital available to reinvest on immediate opportunities. In the example below, a business factors $100,000 worth of invoices at different advance rates. Consider what investment opportunities this business may miss at a lower factoring rate.
In this case, a business that accepts a 70% advance rate may lose out on an opportunity to a competitor with a 90% advance rate. Especially if the opportunity requires immediate financial investment. This is the primary reason that businesses seek to negotiate advance rates and factoring fees on a regular basis with lenders.
Every part of a factoring contract is negotiable between the business and the factoring company. Business owners often negotiate the rates and terms of the agreement, but they should also emphasize a higher advance rate. Getting access to capital sooner enables a business to earn a high return by reinvesting and growing internal operations instead of waiting for the money.