How much does invoice factoring cost for SMBs?

The costs of factoring can be hard to understand. There’s a wide variety of options and contracts offered by factoring companies, each with their own conditions and fine print.

But invoice factoring is still a valuable tool for small businesses. Which means you really need to take a close look at the apparent and hidden costs of the solutions offered by institutions. 

Management fees, the cost of financing cash advances, and administrative charges can all add up quickly. It's natural to wonder whether the advantages of factoring outweigh the downsides.

This article explains each item in detail and provides examples for SMBs. We also explain the indirect costs of a factoring contract as well as other possible invoice financing solutions.

1 - Factoring: definition of key terms

Before going into detail about the cost of factoring, let’s look at the terms used to describe this type of financing and how factoring contracts work.

1.1 - Factoring: definition

In factoring, a company (A) transfers its receivables (invoices) to a factor (B). This factoring company (B) — a financial institution or one of its subsidiaries — then pays an advance to the company (A). 

But this guaranteed cash up front doesn’t come free. Even though (A) benefits immediately from the available cash flow, this financing has a cost. We’ll explore this further shortly.

1.2 - The concept of “reverse factoring”

Unlike traditional factoring, which concerns customer invoices, reverse factoring involves financing accounts payable. This makes sense when (A) needs to pay a supplier (B) quickly, but doesn't have the cash.

This time, it's the supplier (B) who assigns their receivable from the business customer (A) to a financing organisation (C). In exchange, this factor (C) pays the outstanding sum to the supplier (B), in place of the company (A). (A) then reimburses the factor (C) when the invoice is due. This operation is organised at the request of company (A), not the supplier (B). This is why the operation is reversed.

There is also a less complicated version of this process which doesn’t involve (B) directly. (A) simply gets a loan or line of credit from (C), with the express agreement to repay at a later date. Defacto offers both accounts payable and receivables financing in this simplified way.

1.3 - The standard types of factoring contracts

SMBs have access to several classic factoring methods: 

• Standard factoring: your customers are aware of the existence of the contract and send invoice payments directly to the factor.
• Unmanaged or semi-confidential factoring: you inform your customers of the contract, but continue to manage direct collection yourself. You pay the factoring company once you’ve received payment. 
• Non-notified or confidential factoring: the customer isn’t aware of the factoring contract, which exists solely between you and the factor.

Alongside these traditional approaches, fintech companies (like Defacto) offer alternative financing solutions that are more flexible and more immediate. While not technically factoring, they serve the exact same purpose.

2 - Direct costs of factoring

The most immediate and apparent costs of a traditional factoring contract include three distinct items. These are not the only costs, but are the most obvious considerations before accepting a financing offer. 

In total, the cost of factoring, depending on the contract and the quotation, can range from 0.3% to 4% of the amount of invoices assigned.

2.1 - The factor's commission

Factoring fees are designed primarily to cover services provided by the financial institution. 

The factoring commission is used in particular to cover:

• Administrative management of the invoices assigned;
• Follow-up of reminders and debt collection, where applicable (depending on the type of contract signed).

On average, this commission represents between 0.1% and 3% of the amount of the total of receivables assigned to the factor.

2.2 - The cost of financing your cash advance

The factor advances you cash to cover your unpaid customer invoices. So the cost to you depends on the amount of invoices transferred to the factoring company, as well as the financing rate and the term of the advance. 

It also takes into account the level of risk the factor needs to assume. If there’s a high chance that you or your customers won’t pay these debts, the commission will be higher.

This factoring cost item is usually the bank rate plus a percentage ranging from 0% to 2%. 

2.3 - Application fees and ancillary charges

The third classic cost item in factoring is the fee charged for each file signed by the factor. The amount varies according to the nature and quantity of receivables agreed upon.

This factoring cost item includes charges for:

• Setting up the contract
• Managing disputes
• Credit controls
• Penalties for unpaid invoices
• Connection to online services

These additional fees are negotiable. They can amount to a flat fee of around €100 per transaction.

2.4 - Factoring costs: example

Let's take the case of a company with a turnover of around €24 million (including VAT), serving the French market. Customer invoices are on average 60 days overdue. The average amount per invoice is €20,000, with individual invoices ranging from €4,000 to €40,000.

The factoring contract will likely include the following costs (or similar):

• Annual interest rate for financing of 2.5%
• A management fee of 0.2% of annual sales including VAT transferred to the factoring company

Average outstanding invoices are 24 million / 12 months x 2 months = 4 million euros. This represents an annual financial cost for the factor's advances of 4 million x 2.5% = €100,000.

The annual cost of management fees is (24 million x 0.2%) = €48,000. 

In total, the cost of factoring for this SMB is €148,000. And there may be ancillary costs, depending on the negotiation carried out.

3 - Indirect costs that impact business performance

A factoring contract will also have indirect costs, on top of what we just saw above. We'll explain which of these items should be taken into account when analysing your invoice financing quotes. 

3.1 - Hidden factoring costs: the guarantee fund

The factor sets up a guarantee fund to cover the risk of non-payment. It represents a percentage of the average outstanding receivable. The factoring company deducts from the advances granted to the client company until the contractually agreed level is reached.

The money retained by the factor does not return to your accounts. This is pure cost. Don't forget to take this into account in your approach, because the level of the guarantee fund can vary from one factor to another.

3.2 - Additional costs associated with the assignment of all outstanding receivables

Traditional factoring often involves transferring the entire customer receivable to the factor, even if the company only needs cash from time to time. In our example above, we took the total outstanding invoices for a year, which amounted to €4 million. This may be far more financing than you actually want or need. 

As a result, the costs may be too far higher than case-by-case financing solutions.

3.3 - Cumbersome administration and a steep learning curve

Setting up a factoring contract can be complex, including from an administrative point of view. Especially if you still have to manage collections yourself. 

Periodic transmission of invoices issued and payments received, as well as cross-referencing entries in customer accounts, can generate additional work. So there is an indirect cost to consider when choosing a financing solution for your invoices. 

Added to this is the regular checking of the guarantee fund in the company's accounts and cross-checking with the information provided by the factor. And you may want legal or financial advice to navigate this complicated setup. 

All of this costs time and money. 

3.4 - Costs associated with delays

Ttraditional factoring takes time to set up in an SMB. Several months can pass between the first discussions and the actual implementation. 

Each of the following stages takes time and resources:

• Drafting and reading the contract
• Analysing outstanding receivables and validating the third parties selected by the factor
• Studying the terms of credit insurance cover (often required by the factor)
• Customer communications in the case of notified factoring
• Preparing files and accounting entries, and issuing invoices periodically from the accounts to inform the factor.

3.5 - Commercial cost of an impact on customer relations

In certain types of traditional factoring, the factor is responsible for collecting invoices from customers. This form of factoring involves a commercial risk, because you no longer have complete control over customer relations. 

Hopefully there is no negative impact. But this can be detrimental in some cases.

4 - Cheaper working capital financing solutions or options

Factoring has both advantages and disadvantages. The significant direct and indirect costs are major drawbacks of traditional factoring. A lack of flexibility and adaptability to one-off financing needs makes it a rigid, complicated and expensive solution.

Thankfully, alternatives do exist.

4.1 - Flexible, fast and simple solutions for financing customer or supplier invoices

The best financing options should maximise profits and flexibility, without wasting business time and energy. Finance and technology are evolving and coming together through new fintech offerings. These companies now offer cash advances better suited to and more agile for SMBs. 

These solutions are often based on the principle of embedded finance. And while these new financial solutions seem similar to factoring, they are different in some key ways. 

Defacto offers just this type of cash advance. The differences between this solution and factoring can be summarised as follows:

• Immediate start-up, in just 27 seconds, with no need to make an appointment
• Get the finance your company needs and no more, and can finance the specific invoices of your choice
• Obtain the next advance as soon as the need arises, within the credit limit granted
• Finance specific projects directly. The speed with which financial advances are granted means that savings can be kept for specific uses.

This is a smarter form of financing. You can access instant financing for both your customer invoices and your supplier invoices. This then lets you invest quickly in marketing campaigns and boost your sales, as an example. 

Defacto connects to your bank and finance tools, so we can quickly analyse your financial situation. We study all your data in just a few clicks, so that we can provide you with an ultra-rapid response in a simple, transparent and flexible way.

The cost of traditional factoring can be prohibitive for SMBs, especially once you include indirect expenses. Fortunately, new tools and technologies are revolutionising invoice financing.

Defacto is one of these, and we’d love to show much simpler invoice financing can be.