Most conventional factoring transactions are structured as two disbursements. The only exception to this rule is freight bill factoring, in which trucking companies can sometimes get a full advance. For most transactions, however, the standard is two disbursements. The first payment, the advance, can be as high as 85% of the invoice value, and is made once the invoice is received. The remaining 15% is held in reserve until the invoice is paid. Once the invoice is fully paid, the reserve is rebated, less any fees.
Two types of reserves
Most factors hold the reserve until the invoice is paid, at which time it is rebated in full. Other factoring companies may hold a small, ongoing reserve account. Most ongoing reserves are built slowly, to avoid impacting the client.
Reserves reduce the factor’s risk
So why hold a reserve? The simple answer is that it reduces risk. Although many invoices are paid in full, this is not always the case. In some industries, charge backs for defects and other situations are common — creating a potential scenario in which the factoring company could provide an over-advance. Let’s first examine a common transaction.
Assume that the invoice is for $100, the factoring fee is $2, and the advance rate is 85%.
- The invoice arrives and the factoring company advances $85
- 30 days later, the factor receives the $100 payment from the customer
- The factor rebates $13. ($100 – $85 advance – $2 fee = $13)
Now, let’s look at the same transaction, but let’s assume that the advance rate is 98% and that there is a $4 charge back for defective items (which can happen).
- The invoice arrives and the factoring company advances $98
- 30 days later, the factor receives a $96 payment, with a $4 charge back / credit note
- The transaction can’t be settled because the received payment is not enough to cover the advance and the fee
The fact that the transaction can’t be settled creates a problem for both the client and the finance company. The client will have to provide funds so that the transaction can clear. To avoid this problem, factoring companies try to set up reserves sufficient to cover any potential charge backs and credit memos.
One of the most important characteristics of invoice factoring is that it is one of the few business financing solutions that is self-settling (also known as self-liquidating): the transaction settles using the proceeds of the invoice – once it’s paid. Consequently, finance companies need to adjust advance percentages to ensure that the transaction settles properly.
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