Invoice factoring vs. Invoice Financing:
What You Need to Know
Key Takeaways
- Both invoice factoring and financing can free up cash tied up in your invoices. The major difference between the two lies on who owns the invoices at the end and collects the customer’s payments.
- In invoice financing, the company (borrower) retains ownership of the invoices and collects the customers payments. With invoice factoring, the company (borrower) sells the invoices to third-party factoring companies who, then, collects the customers’ payments.
- Invoice financing would be a suitable choice if you have the resources to collect the payments yourself and you’re confident that your customers will pay their dues. On the other hand, invoice factoring may make more sense if you need outside help when collecting payments.
Unfortunately, unpaid invoices are an inconvenient reality for small business owners offering net terms to their customers. “Net term” refers to invoices with a specific payment period (30, 60, or 90 days).
If most of your capital gets tied up in your accounts receivables, your company can experience cash flow gaps that make it harder for you to manage your finances. On top of that, banks are notoriously known to have strict qualifications when it comes to small business loans. As a result, SMB’s have a tougher time securing additional funding to sustain their operations or invest in business opportunities.
Fortunately, invoice financing and factoring are available to small businesses. These small business financing options allow companies to free up cash tied up in their invoices. That way, they will have more capital to sustain their operations and invest in business opportunities.
So, what’s the difference between the two financing options? Here’s everything you need to know about the similarities and differences between invoice financing and invoice factoring.
What is Invoice Financing?
Invoice financing, also known as accounts receivables (A/R) financing, allows businesses to use their customer’s outstanding invoices to get additional funding for their business. In most cases, the financing company can fund up to 80% of the total amount of the accounts receivables.
Once approved, the invoice financing provider advances the funds to you by transferring the entire loan amount to your account or through a line of credit.
When the invoice terms are up, you (the business) will be in charge of the payment collection. After your clients settle their accounts, you’ll have to pay the advanced amount (plus interest and fees) back to the invoice financing company. The interest rates for invoice financing vary by provider. In general, the total fees will range from 1% to 3% per month.
Some invoice financing companies may also connect with your company’s accounts receivables system and automatically deduct the payments once the customer pays their balance.
Invoice financing is an excellent choice for companies with enough resources to handle the payment collection from their customers. Additionally, your customers won’t know that you’re working with an invoice financing company since they will be paying you directly.
Invoice financing is an excellent choice for companies with enough resources to handle the payment collection from their customers. Additionally, your customers won’t know that you’re working with an invoice financing company since they will be paying you directly.
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What is Invoice Factoring?
Invoice factoring works a lot like invoice financing in that the business owners borrow money against their customer’s outstanding invoices. Eligible companies typically receive around 85% to 90% of their total unpaid accounts receivables.
Unlike invoice financing – where you’ll retain complete control of the ledger – the factoring company (or factor) will purchase the invoices and take hold of your company’s accounts receivables. This means that the factor will also be taking over the payment collection.
Once the invoices term is up, the clients will pay the invoice factoring company instead of the business. As soon as every outstanding customer’s invoice has been settled, the factor deducts the advanced amount, along with the agreed-upon interest rate and fees, before forwarding the balance to the borrower.
Since the factoring company will be taking over the payment collection, the customers may be aware that your business uses invoice factoring. Although this isn’t a bad thing, some companies might be uncomfortable with their customers being aware of their relationship with the factoring company. This is why many will prefer invoice financing over invoice factoring.
Some factoring companies may also conduct the payment collection as discreetly as possible. They may introduce themselves as representatives of your company, so the clients won’t know that you’re working with an invoice factoring company.
If you do end up choosing invoice factoring over invoice financing, know that factoring typically comes with higher interest rates than invoice financing. Since the factors will take responsibility for the payment collection, they will set the bar higher for the extra effort. Plus, there’s the possibility that the customers might not pay the invoice, so the factoring company will charge more to offset the risk.
That said, expect to pay between 2% to 4.5% in interest with invoice factoring services. This is significantly higher than invoice financing services which typically have a maximum interest rate of 3%.
Invoice Factoring vs. Invoice Financing: Summary of Differences
| Differences | Invoice Factoring | Invoice Factoring |
|---|---|---|
| Fees | 2% to 4.5% per month. | 1% to 3% per month. |
| Typical amount advanced | Up to 90% of the total invoices financed. | 80% of the total invoices financed. |
| Payment collection | The customers will pay the factoring company. | The customers will pay the business |
| Invoice ownership | The factor purchases the invoices, and therefore, owns them. | The business retains full control of the accounts receivable ledger. |
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Invoice Factoring vs. Invoice Financing: Which One is For You?
When you’re in a cash squeeze, invoice financing and factoring can both be a great alternative to hard-to-qualify bank loans. So how do you know which one is better for you?
Generally, invoice financing will be a better choice than invoice factoring, if:
- Your company is capable of collecting customer’s payments without outside help
- You’re looking for a more affordable financing option
- You want more flexibility when it comes to choosing which invoice to finance
- You don’t want your customers to find out that you’re using the services of an invoice financing company
Invoice factoring is an excellent choice under the following circumstances:
- Your invoices have a term of 60 to 90 days or longer
- You want to offload the responsibility of retrieving the payments from your customers
- You don’t have the resources to collect the customer payments yourself
- You’re comfortable with the fact that your customers might know that you’re using a factoring company
- You can afford the high-interest rate and fees
Ultimately, the best option will depend on the needs and current situation of your business. How much can you afford? Will you need assistance in collecting the payments? Ask yourself these questions before fully committing to the financing
Invoice Factoring vs. Invoice Financing: Advantages and Disadvantages
Advantages of Invoice Financing and Factoring
1. Solves slow cash flow
Some invoices will have a repayment period of 90 days. Instead of waiting for the customers to pay you, you can use invoice financing or factoring to free up much-needed capital tied up in the accounts receivables. That said, you won’t have to worry about late debt payments, payroll, or missing out on a time-sensitive business opportunity.
2. Easy to qualify for
Invoice financing and factoring are usually the go-to financing options for businesses that can’t qualify for a conventional long-term loan. This is because they’re two of the most accessible financing options.
With this type of financing, the lenders will look at your credit score, but it won’t be their primary consideration for approval. Invoice financing and factoring companies typically care more about your customer’s credit standing since the repayments will largely depend on their credit behaviors. So, if you’re planning to apply for invoice financing or factoring, you will have to make sure that your clients are creditworthy to increase your chances of getting funded.
3. No more worrying about late payments
If you’re constantly dealing with late payments, invoice financing and factoring remove the headache of having to worry about slow cash flow in your business. With invoice financing, you can get as much as 80% of funding, while invoice factoring can offer up to 90% cash advance to eligible businesses. This ensures that you have a steady flow of cash to meet your monthly financial obligations on time, like payroll, rent, utilities, and debt repayments.
4. No additional collateral needed
With invoice financing and factoring, your accounts receivables will serve as the asset that will secure the funding. That means you won’t have to present additional assets to use as collateral for the loan. Businesses in their early stages of operation will find invoice financing and factoring a valuable financial resource to get the capital needed to keep their business afloat.
Disadvantages of Invoice Financing and Factoring
1. It can be expensive
The fees associated with invoice financing and factoring tend to be higher than traditional bank loans or long-term loans. The interest rates may also be higher, depending on your customer’s credit standing. In general, the interest rates will range from 2% to 4.5% for each month that the invoices remain unpaid. Some financing companies may even charge weekly fees for the outstanding invoices.
2. You’ll have to cover the payment for the unpaid invoices
If, for some reason, your customer defaults on their invoices, there’s a high possibility that the providers will hold you responsible for the repayment. In that case, you might have to pay the financing company out of your pocket. This could be a major disadvantage, especially if you’re already experiencing cash flow issues and the unpaid invoice is significantly large.
Businesses that Commonly Use Invoice Financing and Factoring
Essentially, any business that offers net term payments can apply for invoice financing or factoring. These particular businesses are more prone to cash flow problems because of unpaid invoices.
Companies that typically apply for invoice financing or factoring most commonly fall into these industries:
- Manufacturing
- Construction
- Recruitment/Staffing
- Transport
- Export
- Security
- Logistics
- Wholesale
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How to Choose the Best Invoice Financing and Invoice Factoring Lender
Choosing the right financing company to work with is vital if you decide to pursue invoice financing. Not only does this ensure that your application process goes smoothly, but it will also guarantee that you’re getting the best terms possible for your current situation.
If you’re in the process of finding the right invoice financing and factoring company, here are a few factors you should consider:
Reputation and experience: Look for companies with a good track record of successful financing transactions in the industry. You can ask for references or check online reviews.
Rates and fees: Compare the fees and rates charged by different lenders. Understand all the costs involved and ask for any hidden fees or penalties that could impact the cost of the loan.
Funding speed: Look for a financing company that could accommodate your timeline. Some offer same-day loans, while others could take several days or weeks.
Customer service: You want to work with a company that’s responsive and easy to communicate with if you have any questions or concerns.
Terms and conditions: Carefully review the terms and conditions of your financing agreement. Take your time understanding all the details, especially the loan terms, fees, and penalties. It’s best to review the contract with a trusted professional.
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Invoice Factoring vs. Invoice Financing: Frequently Asked Questions (FAQ)
1. What documents do I need to prepare?
The documents and paperwork you need when applying for invoice financing will vary by lender, but it will definitely be less than what you’d need to prepare if you were applying for a conventional loan from a bank.
That said, if you’re applying for invoice financing or factoring, here’s a list of documents the lenders will typically ask for from the applicants:
- Driver’s license
- Voided business checks
- Business bank statements
- Business financial statements
- Personal and Business credit scores
It’s possible that the financing or factoring company may require you to submit additional documents, like business leases or other contracts, but this is rare. Be sure to ask the financing company’s representative what you may need so you have everything prepared in the event that they ask for something last minute.
2. How long will it take for the funding to reach my account?
Alternative and online lenders typically offer invoice factoring and financing. Their application and approval processes are faster than that of banks. In general, the earliest time the funds reach your account will be 24 hours after approval.
3. Is it possible to work with the invoice financing or factoring company again?
Yes. One of the biggest pros of invoice financing and factoring is that you’ll get to establish a lasting relationship with your provider. As long as you pay on time, your chances of getting approved for financing again will be higher. Moreover, other providers may even strive to stay on the good side of their clients to increase their chances of doing business with them again in the future.
4. When do I have to pay the loan back?
This will depend on the lender you’re working with. Some may require you to pay the cash advance back within a specific time frame (usually 12 to 24 weeks), while others may allow you to pay once the customers settle the account, which is 30, 60, or 90 days depending on the terms you established. Of course, this is only applicable to invoice financing as invoice factoring companies usually deduct the payment for the borrowed amount once the customers settle their balances.
5. What happens if the customer doesn’t pay their invoice?
The Bottom Line
Invoice financing and invoice factoring are two valuable financing resources that businesses can take advantage of. While they may differ in some aspects, both options are a great solution to solve cash flow issues brought about by unpaid invoices.
When choosing which one best suit your business best, consider your business’s current needs and situation. If you’re confident that you’ll be able to collect payments yourself and want to keep complete control over your invoices, then invoice financing would make more sense. However, if you’re short on manpower to chase payments from customers and don’t mind paying higher fees, then invoice factoring would be a viable choice.
Now that we’ve covered the differences and similarities, you’ll most likely be able to make an informed choice regarding what type of financing best suits your business. Use this as a guide to start improving your business’ cash flow today.
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