Factoring, in finance, is an invoice financing technique that traders, both domestic and international, use to get access to cash by selling their assets (the receivables) to a third party financial institution, also called the factor. The transaction is essentially a sale of an asset (the trade receivable) in exchange for immediate access to funds so a factoring facility can be availed by smaller-businesses over and above their current trading limits.
Factoring is an asset backed financial tool for debt collection. A factoring arrangement works as follows:-
- The client sells goods to its customers (including exporters)
- The client sells the invoices to the factor
- The factor extends advance up to 80% (or more) to the client upfront
- At maturity, the factor collects payment from the customers and pays the remaining amount to the client after adjusting for fees
We have covered the basics of factoring and how it works in an earlier post.
What are the Types of Costs involved in Factoring?
In order to weigh the advantages and disadvantages of a particular factoring service, one of the most important aspects to consider are the costs.
In India, these are usually the costs to be considered in order to weigh the factoring service.
- Interest Rates: The most important cost element, the interest rates on factoring are generally calculated on a monthly basis and can range anywhere between 0.7% per month for good credit profiles, all the way uto 1.5% per month borderline credit profiles. Depending on the indicative date of receipt of the trade payables, the factoring company (factor), will provide for some interest deductions + a buffer amount and will pay out only a percentage (%) of the invoice. The rest of the amount will be paid once the factor receives the payments from the buyer.
The interest rates is also sometimes referred to as the “Discount Rate”
Processing Fees: Almost all factoring companies in India charge a processing fee, which is generally calculated on the total sanctioned facility. This ranges from 0.3% to 1% of the total amount. Drip Capital’s factoring service charges are among the lowest processing fees in the Industry.
Overdue Interest: This is unique to recourse-based factoring programs wherein the obligation of ensuring repayment falls upon the seller. In case of delays in receiving payments, the factor can charge overdue interest, that can be as high as 1-2% per month
Opportunity Costs: While this is not exactly a cost that is implicit in the factoring transaction itself, a business enterprise should consider the following:- a) The opportunity cost in case the business is not able to access the factoring solutions. In the absence of this unlocked capital, the business will not be able to being work on the next order and generate a profit from it. b) Factoring is generally slightly more expensive than traditional trade financing solutions like bank loans. However, other financing techniques are far more cumbersome and long-term in their payment timelines. The opportunity cost of securing delayed capital should also be considered while weighing the viability of a factoring solution.
Maintenance Fees: Some factors also charge a miscellaneous fee for some services like pulling credit reports on the buyers, advisory services - which is very popular in export factoring transactions, and collection fees (in case of collection factoring)
Exhausting collateral security: Since factoring assigns bills receivables to the factor, the seller does not hold any control over them. They cannot be provided as collateral security while obtaining any other type of finance.
Sometimes the factor also provides debt collection and maintenance services.
These industry-standard factoring costs are not uniform and change as per the industry, business type and also from factoring agency to agency.
Pricing Aspects to Consider in Factoring
As mentioned earlier, factoring companies follow differential pricing techniques, which means that not all customers are charged the prices. The actual pricing will vary depending on the perceived risks for the factor, size of the facility, nature of the business etc.
Some of these aspects that a factoring company may consider before finalizing a price can include;
Financials: The financial statements, including balance sheets and income statements from the borrowing companies are requested in order to evaluate the health of the business, the growth trajectory, and the company’s ability to successfully execute orders profitably. An over leveraged balance sheet or diminishing profitability is construed as a risky transaction which will warrant higher pricing.
Business Vintage: Much older businesses with a proven vintage are far more likely to enjoy a better pricing as opposed to nascent companies.
Number of Shipments: A significant factor to consider, especially for in the case of international factoring, the number of shipments that a supplier ships out to other countries is a noteworthy aspect that factoring firms take into account before making disbursements.
Credit Profile of the buyer: Since the ultimate party that is making the payment is the buyer from the importing company, factoring companies may sometimes charge a higher pricing for buyers that they deem particularly risky or may even outright reject them
How is factoring cost calculated?
Factoring fees are usually calculated by applying the discount/interest rate to the amount advanced against the invoice. But in some cases, it can be charged against the total invoice value, this is something that borrowers need to watch out for.
The first step of the calculation is based on the interest cost or the discounting cost.
Factoring rates can be quoted as flat rates or variable rates. Under flat rates, one single rate is charged irrespective of the period for which the invoice remains open.
Example 1: Invoice face value: INR 1,000, Advance rate: 80% (*Advance rate is the percentage of invoice value that is extended as advance). The remaining 20% of the amount that the factor will receive at the due date along with the entire amount will be kept as a buffer to cover overdue interest, processing fees etc.
Amount advanced: ₹ 800
Quoted discount rate: 1.5%
If calculated on amount advanced = ₹ 800 x 1.5% = ₹ 12
If calculated on invoice value =₹1000 x 1.5% = ₹15
Most well-known factoring companies charge interest rates based on the factoring amount value. If not, the borrowers should consider this as a red flag and investigate further.
Although quite rate, Some companies may also charge a variable rate, which we’ve explained with an example below;
Example of flat rate: Quoted discount rate: flat 4% for 60 days.
Amount advanced: ₹100
The fee on your ₹ 100 invoice if it's paid in 60 days would be:
₹ 100 x 4% = ₹ 4.00
Total factoring fee = ₹ 4
Example of variable rate:
Quoted discount rate: 2% flat discount Rate for the first 30 days and an additional 1% flat discount rate for every 30 days afterwards.
The fee on your ₹ 100 invoice if it's paid in 60 days would be:
First 30 days: ₹ 100 x 2% = ₹ 2.00
the next 30 days: (₹100 x 2%) +(₹ 100 x 1%) = ₹ 3.00
Total factoring fee = ₹ 2 + ₹ 3 = ₹ 5
The processing fees and maintenance fees on either the overall sanctioned facility or the advanced amount can be calculated as a simple percentage and be added to the total factoring cost.
FAQs on Factoring Costs
Who pays the factoring company?
The buyer of the customer makes the payment directly to the factoring company
Who bears the cost of factoring?
The cost of factoring is borne by the business that discounts the invoices
Are factoring fees tax-deductible?
Factoring fees are classified as a business expense and are tax-deductible
What is the potential cost of not factoring?
The business can face liquidity issues leading to working capital mismanagement especially in busy seasons and might have to put more effort into administrative processes for securing a conventional loan instead of concentrating on core areas of the business. This can cost quite a lot, especially for a small or medium business.
Do factors charge less than banks?
Not necessarily so. Both banks and factoring companies charge interests on a differential pricing model. Which can vary significantly on a case to case basis
Are Factoring Fees Considered Interest?
Yes, factoring fees is the same as interest expense that the factor deducts from the unadvanced amount and pays the customer back at the due date
