When a company runs short on cash flow, they often turn to business loans to fund their daily operations. But for business owners who aren’t too keen on taking on additional debt, invoice financing or accounts receivable financing may be their best option.
There are two main types of invoice financing: invoice factoring and invoice discounting. While they both serve the same basic purpose, they work differently and have their own unique benefits. Unfortunately, many business owners don’t know the difference between the two.
In this article, we'll break down the key distinctions between invoice factoring and invoice discounting to help you choose the right option for your business. Whether you're an experienced entrepreneur or new to business finance, keep reading to know more about invoice discounting vs invoice factoring and make smarter financial choices for your company's future.
What is Invoice Factoring?
Invoice factoring or accounts receivable factoring is a financing option where businesses' sell’ their outstanding invoices to third-party companies or an invoice factoring company at a discount. The terms and conditions involving invoice factoring usually vary, but a majority of factoring companies provide between 60% and 80% of the total value of an invoice.
Invoice factoring removes a lot of the worry surrounding the management of your invoices. Factoring companies take on the responsibility of overseeing credit control, processing invoice payments, and collecting payments from customers.
Pros of Invoice Factoring
- Improved Cash Flow
Business invoice factoring allows businesses to access cash quickly by selling their unpaid invoices to a factoring company.
- Faster Payment
Instead of waiting for customers to pay their invoices, factoring provides fast funding, typically within a few days.
- No Debt
Invoice factoring is not a loan, so it doesn't create debt for the business.
- Flexible Funding
Factoring companies can provide funding based on the volume of invoices, allowing businesses to scale their financing as needed.
- No Credit Check
Factoring is based on the creditworthiness of customers, not the business itself, making it accessible to companies with poor credit.
Cons of Invoice Factoring
Factoring companies charge a fee for their services, which can be higher than traditional loans.
- Loss of Control
By selling invoices, businesses give up some control over their customer relationships and the collection process.
- Potential Damage to Reputation
If customers are not accustomed to receiving payment requests from a factoring company, it could negatively impact the business's reputation.
What is Invoice Discounting?
Like factoring, invoice discounting is a short-term financing option where business owners borrow money against outstanding invoices from invoice discounting companies. Entrepreneurs often use invoice discounting to help improve working capital and cash flow.
Invoice discounting allows you to retain control over your sales ledger, payment collections, and invoice processing. Unlike invoice factoring, your customers will remain unaware of the transactions between you and the lender.
Pros of Invoice Discounting
- Improved Cash Flow
Similar to factoring, invoice discounting provides businesses with quicker access to cash by using unpaid invoices as collateral.
- Retain Control
Unlike factoring, with discounting, businesses retain control over the collection process and customer relationships.
Invoice discounting can be done confidentially, meaning customers may not be aware that their invoices have been used as collateral.
Cons of Invoice Discounting
- Requires Creditworthiness
Invoice discounting is typically available only to businesses with a strong credit history and reliable customers.
- Debt Obligation
Unlike factoring, invoice discounting involves taking on debt, as the business is responsible for repaying the funds obtained from the lender.
- Potential Additional Costs
Additional fees, such as interest charges and administrative costs, may be associated with invoice discounting.
What is The Difference Between Invoice Discounting and Factoring?
Both invoice factoring and discounting involve borrowing against outstanding invoices. However, you can narrow the main difference between the two to the one who controls the sales ledger and collects customer payments. To be more specific, here is what differentiates one from the other.
Factoring: In factoring, the factoring company buys your unpaid invoices, effectively taking ownership of them. This means the responsibility for collecting customer payments shifts to the factoring company. They handle the invoicing and payment collection, allowing you to focus on other aspects of your business.
Discounting: With discounting, your business retains ownership of the invoices. This means you're responsible for managing your customer relationships and collecting payments. The financing company provides an advance based on the value of your invoices but doesn't take control of the collection process.
Factoring: In a factoring arrangement, your customers are aware of the arrangement because the invoices typically instruct them to make payments directly to the factoring company. This transparency may or may not impact your customer relationships, depending on how well the factoring company handles the collections process.
Discounting: Customers are often unaware of the financing arrangement in invoice discounting. They continue to make payments to your business and repay the financing company. This can help maintain smoother customer relationships as there's no direct involvement of the financing company.
Factoring: Factoring is usually not very confidential since customers know about the factoring arrangement. This transparency can be a drawback for businesses that want to keep their financing details private.
Discounting: Invoice discounting can be more confidential because it doesn't involve direct customer notification. This discretion can be advantageous if you prefer to keep your financing arrangements confidential.
Control and Responsibility
Factoring: When you opt for factoring, the factoring company takes on various responsibilities, including credit checks, payment processing, and collections. This can be beneficial if you want to offload these tasks and focus on core business activities.
Discounting: In discounting, your business controls credit management and customer relationships. You continue to handle credit checks, invoice processing, and collections. This may be preferable if you want to retain autonomy and hands-on control.
Factoring: Factoring services often come at a higher cost than discounting because they include additional services like credit control and collection efforts. The convenience factor of these services can justify the higher fees for some businesses.
Discounting: Invoice discounting typically has lower fees because it primarily involves providing an advance based on the invoice value without the added services offered in factoring. This can make it a more cost-effective option.
Ultimately, your choice between invoice discounting and factoring should align with your business's specific needs, customer relationships, and financial preferences. Each option has advantages and drawbacks, so it's crucial to consider what matters most to your business when deciding.
Which Financing Option is Right for You?
Choosing between invoice factoring and invoice discounting shouldn’t be as overwhelming as it seems. The type of financing you choose will depend on your company's size and your sales ledger management needs.
If you run a small company and your resources are limited, you can use the credit control and payment collection service that comes with invoice factoring to your advantage. On the other hand, for larger companies with a debt collection process in place, or if you want to handle your own sales ledger, invoice discounting may work better for you.