Understanding Factoring Company Fees

December 1st, 2008 Filed under: Uncategorized — Accounting Author

Selling account receivables, better known as factoring, has become very popular with businesses facing cash flow issues. If you are new to the concept of factoring and considering it as a finance option, the issue of how fees are charged can be a bit confusing.

We need to first discuss how factoring works. The simple answer is you sell an invoice to a factoring company. In exchange, the factoring company gives you a discounted amount of the face value of the invoice. For instance, let’s assume I sell a $10,000 invoice payable in 30 days to the Blue Factoring Company. Blue will give me $9,700 in exchange for it. The advantage of this approach is I get money now to help my business with cash flow. The disadvantage is I am giving up some of my profit in the form of the factoring company fee.

This example is illustrative in that it describes the basic concept of factoring. That being said, it is not entirely accurate when it comes to the fees paid. Why? Well, factoring companies are evaluating the risk of buying the invoice from you. In doing so, they shift some of that risk to you.

A factoring company takes on risk when it buys an invoice. What is the risk? The risk is that your client will not pay the invoice. This is a rather obvious risk, but there is a secondary subtle risk as well. That risk is your client will be slow in paying. Time is money. The longer the factoring company has to wait to get paid, the less profit it makes on the transaction. While factoring companies can help your business with cash flow, have no doubt that they are in the game to make a profit!

The majority of factoring companies will compensate for this secondary risk in an interesting way. They will insist on a graduated fee agreement. The longer it takes the client to pay, the higher your fee goes. This effectively insulates them from at least part of the risk. Depending on the transaction, some may insist you personally guarantee the transaction as well.

If you have been paying attention, you’ve probably seen a serious problem with this approach. Since the factoring company has already paid you, how is it going to recover any additional fee? Well, the powers that be at the factoring company are not insipid. They will insist on escrowing part of the invoice payment, usually 20 percent. If the client delays in paying the invoice, the additional fee is taken from the escrowed amount.

Let’s look at our example again. I sell my $10,000 invoice to the factoring company. They agree to pay me $9,700 so long as the invoice is paid on time by my client. If the client is late, the fee goes up a quarter percent a day. I agree to this and they issue me a check for $8,000. If my client pays the invoice on time, the factoring company will then forward the remaining $1,700 to me. If my client is late, the factoring company will forward the appropriate reduced amount when payment is finally made.

The simple lesson from this is that you should only factor invoices from clients that pay reliably. If you have a client who is always late making payment, do not risk losing your shirt by selling their invoices to the factoring company.

Stephen Teak writes about the history of factoring and other finance subjects for FactoringCompanyInformation.com.

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