Most factoring transactions don’t use a full advance. Instead, they advance less than 90% of the invoice and hold the rest as a reserve. This reserve is rebated once the transaction settles. The reserve is an essential component of a factoring transaction. It reduces the chances of having settlement problems. This article explains how the reserve works, why factors use it, and provides some examples. We cover:
- How do most factoring transactions work?
- What is a factoring reserve?
- Why do factoring companies need a reserve?
- What determines the size of the reserve?
1. How do most factoring transactions work?
To understand the reserve, you must understand how factoring transactions are structured. Most transactions are structured as invoice purchases. The factor buys your accounts receivable and pays for you them in two installments.
The first installment is called the advance. It covers 80% to 90% of the total value of the invoice and is deposited into your bank account shortly after you factor the invoice. The remaining 10% to 20% of the invoice is held back as a reserve. These funds, less the fees, are rebated into your account as soon as your end customer pays the invoice in full. This payment settles the transaction. To learn more, read “How Does Invoice Factoring Work?“
2. What is the factoring reserve?
There are two types of reserves in factoring. Some transactions have only one type of reserve, while others use both. Understandably, this difference can be a source of confusion for clients. In most transactions, the reserve is simply the name of the second installment. This refers to the amount that was held back and is rebated when your customer pays and the transaction settles.
Some transactions require the factoring company to set up a second reserve. This reserve is used when normal reserves won’t be sufficient to smooth out transactions. The second reserve is not based on an invoice percentage. Instead, it has a pre-determined value. The factor holds back a small percentage of every transaction and adds the funds to the reserve. This type of reserve is used in transactions that are subject to unusual chargebacks.
3. Why do factoring companies need a reserve?
Factoring companies hold a reserve because it reduces the finance company’s risk, and it smooths out transactions. A transaction without a reserve has no margin for error. This scenario has implications for the client and the finance company. This situation is best explained with an example.
a) Let’s consider a transaction with no reserve
Let’s examine a transaction that has no reserve. Assume that a factoring client wants to finance a $1000 invoice. The factoring company provides a full advance at 98% and charges a 2% transaction fee.
However, the end customer finds some problems with the delivery and pays only $970. Let’s examine the transaction’s flow and settlement:
The factoring company expected a $1,000 payment but only got $970. The customer’s payment is less than the factor’s advance. Consequently, the transaction cannot settle. The factor cannot recover the $980 advance it gave the client nor charge its $20 fee. The only way to settle the transaction is to charge $30 to the client. Now, the client faces an unexpected $30 cost that it must manage.
b) Reserves smooth out transactions
Having a reserve smooths out transactions and helps ensure a smooth settlement if there is an underpayment. Let’s look at the transaction from the previous example. However, this time the advance is the typical 85%.
The factor settles the transaction by subtracting the advance and the fee from the customer payment. In this case, $970 – $850 (initial advance) – $20 (2% fee) = $100. The $100 is rebated to the client to settle the transaction.
c) Reserves reduce the factor’s risk
The reserve also plays an important role in reducing the factoring company’s risk. Factoring companies want to avoid situations in which they are owed money by clients. An adequate reserve can help ensure that transactions settle easily without having to collect funds from clients.
4. What determines the size of the reserve?
The types and size of reserves depend on your industry, track record, and the factoring company. Some industries, such as trucking and staffing, qualify for minimal reserves. The average reserve is 10% in these cases, but it can be lower. A low reserve is possible because the payment patterns of the industry are well-known, and verifying invoices is simple.
The transaction reserves in most industries range from 15% to 20%. However, factors can increase the reserve or use a secondary reserve if transactions have uncommon chargebacks or unusual product return clauses.
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