A factor quotes a discount rate and a commission as if they were separate prices. Annualised on the cash actually received, they are one rate, and it is higher than either.
Add the service commission to the discount charge, divide by the cash actually advanced, and annualise over the days the invoices are outstanding. On an illustrative 1,000,000 of invoices factored at an 85 per cent advance, a 7.60 per cent discount and a 0.55 per cent commission cost 18,061 over 70 days: an effective annual rate of 11.08 per cent, not 7.60.
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An exporter sells 1,000,000 of invoices on 60-day terms to a factor. Its customers actually pay in 70 days on average. The factor advances 85 per cent at once, holds the other 15 per cent as a reserve until collection, charges a discount on the funds advanced for the days they are outstanding, and charges a service commission on the invoice face. The rates are illustrative; quoted terms vary widely by sector and debtor quality.
| Input | Value |
|---|---|
| Invoices sold, face value | 1,000,000 |
| Advance rate | 85% |
| Cash advanced | 850,000 |
| Reserve held until collection | 150,000 |
| Discount rate, per year, actual/360, on the advance | 7.60% |
| Service commission, on face | 0.55% |
| Days outstanding, actual | 70 |
| Comparison: overdraft rate, actual/365 | 8.40% |
The two charges have different bases and different clocks. The discount runs with time on the cash advanced; the commission is a flat percentage of the face, paid once. To compare the result with any other source of money, both have to be expressed as a cost of the cash received, per year.
Commission = face × 0.55% = 1,000,000 × 0.55% = 5,500
Discount = advance × 7.60% × days / 360 = 850,000 × 7.60% × 70 / 360 = 12,561
Total cost = 18,061, which is 2.12% of the cash advanced and 1.81% of the face
Effective annual rate = total cost / advance × 365 / days = 2.12% × 365 / 70 = 11.08%
Excel: =(Face*Comm+Adv*Disc*Days/360)/Adv*365/Days
Split the 11.08 per cent into its parts. The discount, restated on a 365-day year, is 7.71 per cent. The commission adds 3.37 per cent. The quoted rate is less than three-quarters of the true one, and the part nobody quotes as a rate is almost a third of the total.
Compare it with the overdraft the exporter already has. The same 850,000 for the same 70 days at 8.40 per cent costs 13,693. Factoring costs 18,061, or 4,368 more, an effective premium of 2.68 percentage points a year. That is not necessarily a bad price. It is the price of what factoring adds: the factor runs the sales ledger, chases the debtors and, on a non-recourse facility, carries some of the credit risk. The question to put to the facility is whether those services are worth 4,368 on this batch of invoices, not whether 7.60 is lower than 8.40.
For factoring to cost no more than the overdraft on this batch, the commission would have to fall to 0.11 per cent of face. Anything above that is a fee for the service, and should be judged against what the service replaces.
The commission does not shrink when the invoices are paid sooner. Spread over fewer days, it weighs more heavily on the annual rate, so a business with prompt payers pays the highest effective price for the same terms.
| Days outstanding | Commission | Discount | Total | Effective annual rate |
|---|---|---|---|---|
| 30 | 5,500 | 5,383 | 10,883 | 15.58% |
| 45 | 5,500 | 8,075 | 13,575 | 12.95% |
| 60 | 5,500 | 10,767 | 16,267 | 11.64% |
| 70 | 5,500 | 12,561 | 18,061 | 11.08% |
| 90 | 5,500 | 16,150 | 21,650 | 10.33% |
| 120 | 5,500 | 21,533 | 27,033 | 9.67% |
On these terms the effective rate never falls to the 8.40 per cent overdraft until the invoices are outstanding for about 340 days, which no trade receivable should be. The drafting of the agreement moves the answer as much as the rates do:
| Variant | Cash advanced | Total cost | Effective annual rate |
|---|---|---|---|
| Base case: discount on the advance | 850,000 | 18,061 | 11.08% |
| Discount charged on the full face | 850,000 | 20,278 | 12.44% |
| Advance rate cut to 80% | 800,000 | 17,322 | 11.29% |
| Only half the advance drawn | 425,000 | 11,781 | 14.45% |
The last row is the one that catches businesses using factoring as a standby: the commission is due on every invoice assigned, whether or not the cash is drawn, so drawing half the advance pushes the cost to 14.45 per cent a year.
The usual error is to compare the factor's discount rate with a bank's lending rate, as if the commission were an administration charge outside the cost of money. It is part of the cost of money, and at short collection periods it is half of it: at 30 days the commission is 51 per cent of the total charge. The second error is to annualise on the face rather than on the cash received; the reserve is the exporter's own money held back, and it earns nothing. The same base error, a rate applied to one amount and earned on another, makes a lower discount rate the dearer arrangement when set against a facility that funds only the cost of the goods.
Receivables purchase is priced alongside the other five routes to payment, with commission, discount and dilution kept apart, in the free workbooks for the book's export order.
Because the service commission is charged once on the invoice face, whatever the period. On 1,000,000 of invoices the 5,500 commission is spread over 70 days in the base case and over 30 days if customers pay quickly. The effective annual rate rises from 11.08 per cent to 15.58 per cent with no change in the quoted terms.
It depends on the agreement, and it matters. Charged on the 850,000 advanced, the discount over 70 days is 12,561 and the effective rate 11.08 per cent. Charged on the full 1,000,000 face, it is 14,778 and the effective rate 12.44 per cent, although the cash received is the same.
Annualise both on the same cash for the same days. An 8.40 per cent overdraft on 850,000 for 70 days costs 13,693; factoring costs 18,061, or 4,368 more. That difference is what the factor's credit control, collection and any credit protection must be worth to justify the arrangement.
This article is one calculation from Trade Finance. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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