Invoice Factoring Vs Discounting

When considering the different methods of business financing, invoice factoring and discounting are preferred options because they allow the business to secure short-term financing without giving up any of its [fixed] assets or getting into debt.

They are quite similar financing methods with similar approaches, but slight differences can make one preferable over the other depending on your business's needs.

What is Invoice Factoring?

This business financing method leverages your account receivables and turns them into instant cash. The invoice factoring company takes up your unpaid invoices and gives you up to 80% of the value of the invoice upfront as they wait for the client to clear the invoice.

For many businesses, the cash flow pitfall is the time it takes clients to clear the invoice once they receive it. Invoice factoring can help fix this problem by helping you unlock most of the cash in the invoices sooner to keep up with your expenses.

The invoice factoring terms depend on the factoring company and your agreement with them. The company can advance up to 80% of the value of the invoice and the balance once they receive the full payment from your client, less their charges.

The factoring company usually manages or partners in credit control and processing invoice payments, which means your clients know the third party relationship.

Benefits of Invoice Factoring

There are several reasons why you should consider invoice factoring as a preferred business financing method, such as:

  • The factoring company looks after your sales ledger, manages the credit and controls the process. This saves your business from having an elaborate credit control unit and frees you up to continue running the business as the factoring company chases the outstanding payments. This can save vital resources for your business and reduce losses from bad debtors.
  • Factoring companies have enhanced credit checking processes, making you more likely to trade with customers who will pay on time. By leveraging such features, you can ensure you work with customers with positive credit ratings and can keep up with their invoices.
  • Invoice factoring can enhance your cash flow, allow you to pay your suppliers on time, and consequently negotiate better terms with them because of the timely payments.

The Downsides of Invoice Factoring

Invoice factoring also has downsides, which you should consider to give you a balanced view.

  • You might lose customers who know they are dealing with a factoring company and prefer to deal with you. However, if this rarely occurs you can always elect to keep them out of the facility as one option around that.
  • A factor’s presence may impact the customer’s impression of your business. This is more likely when the factor handles the customer badly. As with anything, choosing the right partner and asking for testimonials are needed here.
  • Invoice factoring comes at a cost. Management fees may take up to 2.5% of the turnover and other fees and interests that can dig into your profits.

What is Invoice Discounting?

Invoice discounting is another type of business finance using your account receivables. It is almost the same as borrowing against your unpaid invoices, but with a few differences.

With invoice discounting, you sell the invoice to the factoring company at a discount, and the factoring company sends you the agreed amount to your account.

The main difference is that with invoice discounting, the factoring company doesn't take over the responsibility of the collection of your sales ledger; you still have to chase the payments and process the invoices. As a result, customers may not be aware of your relationship with the lender. But this only works if you have a diligent accounting department that will keep up with the payments.

Benefits of Invoice Discounting

Some of the benefits of invoice discounting include the following:

  • The arrangement can be confidential, so your customers don't know about it or that you are borrowing against their invoices.
  • You manage the accounts, allowing you to build and maintain a customer bond.
  • The fees are more affordable than invoice factoring because there are no additional services with invoice discounting.
  • There is less risk, and you don't have to worry about the discounting company mishandling your customers.

The Downsides of Invoice Discounting

  • To be accepted by the invoice discounting lender, you need a strong in-house credit collection process and system. Such systems can be costly to set up and maintain.
  • Invoice discounters only want to work with businesses with a higher turnover to maximise their profits and businesses with a positive net worth on their balance sheet. However, these terms can vary depending on the provider you choose to work with.
  • Some businesses rely on invoice discounting as a source of cash and find it difficult to leave the arrangement without impacting their cash flow.

Differences Between Invoice Factoring and Discounting

From the descriptions, you can tell there are slight differences between invoice discounting and factoring. But there are more:

Visibility and Control

  • Factoring companies take over the management of your sales level and credit control. They chase customers on your behalf, allowing you to focus on running your business.
  • With invoice discounting, you maintain the full responsibility of chasing invoices and managing credit control, which can be tedious but allows the discounting company to maintain anonymity.

Adjustments to advances and the funds available

  • Invoice factoring provides you with funds for individual invoices. The funds you receive are adjusted daily.
  • Invoice discounting requires you to provide a monthly reconciliation of the account that reflects any changes in the level of debt to be disallowed. The finance provider can then make adjustments, which can be harder to manage.

Risk

  • Invoice factoring is less risky to the lender because they manage the credit aspect and may chase the invoice. This is why factoring is more popular and easier to get approved.
  • Invoice discounting is riskier for the lender. The lender has no direct contact with the debtors and no control over them. To reduce risks, discounters only work with companies with a positive balance sheet and a high net worth.

Which is Right For You?

Now that you know what each financing option offers, you can choose the one that suits your business needs best. When choosing, you must consider factors like your business's size and ability to manage your sales ledger, among other key considerations effectively.

If you’re a small business that has had problems collecting payments in the past, invoice factoring might be more beneficial because it saves you the trouble of chasing the payment and maintaining a credit control department, which can be expensive. But invoice discounting can also work for you if you already have such a department.

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