Factoring is a type of financing transaction that helps companies improve their cash flow. It finances slow-paying invoices, providing companies with working capital to operate the business more effectively. This article discusses how factoring works, how transactions are priced, and how Canadian factoring companies set up accounts. We cover:
- How does it work?
- The advance
- The application process
- How are invoices funded?
- Qualification requirements
1. How does invoice factoring work?
Factoring transactions are commonly structured as the sale of your accounts receivable in exchange for a payment. The factor buys the invoices from your company at a discount and settles the transaction once your end customer pays their invoice 30 to 60 days later.
Most transactions are financed in two instalments. The first instalment, called the advance, covers between 80% and 90% of the invoice. It is deposited into your bank account shortly after you submit the invoices for funding.
The second instalment covers the amount that was not advanced, less the factoring fee. This instalment is deposited into your account once your client pays the invoice in full. Here is a summary:
- Your company delivers the goods/services to your client
- You submit an invoice for financing
- The factoring company advances 80% to 90% of the invoice
- Your client pays after 30 to 60 days
- The factor deposits the remaining funds, less the finance fee
There are variations to this transaction format, but most factoring companies use it. To learn more, read “What is Factoring?”
2. The advance (1st instalment)
The advance is the initial financial instalment that the factoring company gives your company. It’s based on a percentage of the invoice’s face value. The advanced percentage varies by client industry and transaction risk. The average advance is 85%, though it can range from 80% to 97%. Here are examples of typical factoring advances for different industries:
- Staffing: 90% to 95%
- Transportation: 90% to 97%
- Oil and gas: 80% to 95%
- Manufacturing: 80% to 90%
- Consulting: 80% to 95%
- Distribution: 80% to 85%
- Construction: 75% to 85%
Pricing for factoring transactions varies by volume, industry, and risk. For most companies, clients can expect the “all-in” pricing to range from 1.5% to 4.5% per 30 days. Most factoring companies implement a pricing structure using one of the following options.
a) Flat fee
Flat fee pricing is simple and popular among small carriers in the transportation industry. The factoring company charges you a fee of X% as a single fee. For example, the factor could charge your company a flat fee of 3% to purchase your invoices.
b) Percentage for a block of days
In this model, the factoring company charges a percentage for a recurring number of days. For example, they could propose a factoring fee of “1% per every ten days” (1% for every ten days the invoice is outstanding). A ten-day interval is typical, but factors also use 15-day and 30-day intervals. Some factors also use a combination of intervals, such as “2% for the first 20 days, and .1% per day after that.” This model is commonly called “tiered pricing” in the industry.
c) Discount fee and outstanding utilized balance fee
Factors can also charge an initial, small, flat fee and a fee tied to the outstanding balance. For example, they could charge an initial discount of X% and a fee of Y% per day on the utilized funds. This structure is commonly used for larger companies.
4. The application process
The application and due diligence process are fairly simple, especially when compared to bank financing options. The process usually takes about a week, though timeframes vary. In cases where the factoring company gets all the information they need in a timely manner, the process can be completed in a couple of days.
Step #1: Submit an application
The first step is to submit an application to the finance company. You will usually need:
- A/R Aging Report
- Relevant permits
- Corporate documents
Step #2: Factoring company performs its due diligence
Once they have the application information, the factoring company begins its due diligence review. During due diligence, the finance company reviews your client’s commercial credit, among other criteria.
Step #3: Review the factoring proposal
The factor will provide a proposal if the factoring company’s due diligence is successful. The proposal outlines the terms of the service and the cost. If the terms are agreed upon, the factor provides you with legal documents.
Step #4: Sign legal agreements
If both parties agree to the terms of the contract, they execute it and begin the process of financing invoices. If it has not already done so, the factor secures its collateral using the PPSA (or a hypothèque in Quebec). Once these arrangements are in place, your account is ready to be funded.
Step #5: Review customer’s creditworthiness
The factoring company determines your customer’s creditworthiness through a commercial credit bureau, such as D&B. Factors can finance invoices only from customers who have an acceptable commercial credit rating. Some factoring companies monitor your customer’s credit regularly.
Step #6: Send notice of assignment (once per client)
Each customer whose invoices you factor needs to be notified of the relationship through a notice of assignment. This document is sent once to each customer at the beginning of the relationship. It explains how payments must be handled.
5. How are invoices financed?
Once everything is set up, your company is ready to finance invoices. The process can be repeated as often as needed, as new invoices are generated and old invoices are paid.
Step #1: Submit the batch of invoices
Submit the batch of invoices – electronically or by fax – to the factoring company.
Step #2: Invoice verification
The factor performs a random verification of the invoices to ensure that they are correct and still outstanding. The process is simple and is done via e-mail, through a phone call, or your client’s vendor portal.
Step #3: Factor deposits 1st instalment (the advance)
Once invoices are verified, the factor submits the advance to you through an ACH, bank wire, or cheque. Usually, the advance can be paid within a day of invoices being submitted.
Step #4: Customer pays. Factor deposits 2nd instalment
Once your customer pays the invoice in full, the factoring company calculates the settlement amount. This amount is deposited into your bank account at set intervals, though this interval varies by factoring company.
6. Qualification requirements
Qualifying for factoring is easier than qualifying for conventional financing of comparable size. Your company should have:
- Clients with good commercial credit
- Invoices that are free of liens
- 15% or greater profit margins
- Experienced management (or owners)
Get more information
Are you looking for a factoring quote? We are a leading factoring company and can provide you with high advances at low rates. For information, get an online quote or call us toll-free at (877) 300 3258.