To make it easier to understand, let’s look at an example:
Let’s say you have $100,000 on an outstanding invoice with 30 day terms. It’s quarterly tax time and the end of a payroll period, so you can’t afford to get behind on receivables, nor do you have time to worry about collecting it. To address your cash flow concerns, you approach the invoice factoring company about taking this invoice off your hands so you can get back to business.
To factor your invoices, the company would offer you an immediate $80,000 and hold $20,000 in reserve. From there, the company will work directly with your customer to collect the $100,000 from the customer. The factoring company could then apply a 3% administration processing fee ($3,000) along with a factoring fee to the monies in reserve. A common factoring fee is 1% for each week the invoice is outstanding—so, for example, if the customer pays their invoice within two weeks, your factoring fee would be two percent.
In this example, the factoring company will retain $5,000 of the $20,000 reserve. You’ll receive $15,000 once the account has been settled. Overall, you’ll see $95,000 of the original $100,000 amount receivable.
You sell $100,000 invoice with 30-day terms
Factoring company advances you $80,000 and holds $20,000
Customer pays invoice 2 weeks before due date
Various fees are owed to the factoring company:
$3,000 (3% processing fee)
$2,000 (1% per week they held the balance)
Factoring company pays you the remaining $15,000
Total revenue collected: $95,000 Total fees paid: $5,000