Invoice factoring and invoice discounting are two related but distinct financial methods for receiving funds for unpaid invoices upfront — I.e., before the client has paid you for services rendered.
Invoice discounting consists of a loan, whereas invoice factoring is when a financial company purchases your invoices at a slightly discounted price.
We’ll cover the differences in more detail below, as well as everything else you need to know about the invoice factoring Vs. invoice discounting debate.
What is invoice factoring?
Invoice factoring is a type of financing that can help smaller businesses access cash quickly.
It consists of selling unpaid customer invoices to a third-party invoice factoring company.
When the factoring company purchases outstanding invoices from a business, they send a fraction of the invoice amount upfront.
They can then collect payment from customers within one to three months. Once settled, the factoring company pays the remaining amount to you.
How does invoice factoring work?
Invoice factoring uses your outstanding invoices and turns them into immediate cash.
If your business needs $10,000 upfront to buy a new printer or upgrade software, but you don’t have the budget for this, you can try factoring invoices.
This means looking to accounts receivable to see what you’re owed — and then getting that money faster.
You might find you have the capital you need in the form of outstanding invoices, in which case you can sell these to a factoring company.
That company might then create an invoice factoring agreement with you and buy your accounts receivable for the value of the invoices, minus a fee of about 3%.
If you agree to their terms, the invoice factoring company will pay you a total of $9,700 for the invoices and keep their 3% (aka $300).
The company will typically send you a cash advance for a portion of the total purchase within a couple of days—usually around 80-85%.
When the invoices are fully paid, they’ll send you the remaining balance.
What is invoice discounting?
Invoice discounting is a financial method that allows you to gain access to money from your customer’s unpaid invoices.
It’s essentially a form of short-term borrowing.
The discounting company lends your business a predefined portion of the value of the invoice from your accounts receivable.
Once you sell, you’ll get a percentage of the invoice value billed to your customer.
Here’s an example of invoice discounting:
Your service provider company takes bulk orders for manufacturing pianos.
The receiver company has agreed to pay for the pianos 60 days after receiving the orders.
After completing and delivering the orders, your piano manufacturing company receives another bulk order.
However, you’re now short of funds for manufacturing since you’re still waiting to receive payment for your first order.
This is when you can turn to invoice discounting.
Your company can apply for invoice discounting with a third-party financing company. They might offer to lend you 85% of the outstanding invoice upfront, for example.
Once you receive the full amount from your customer, you pay back the money to the financing company, plus their fee, which will have been settled on when you made the agreement.
Invoice discounting vs factoring
Invoice discounting, also known as invoice financing or accounts receivable financing, consists of borrowing money against outstanding accounts receivable.
A financing company will lend you a portion of your unpaid invoices (often around 85%).
Once your customer pays their invoice, you pay the lender the amount loaned, plus any lending fees or interest.
With invoice discounting, the responsibility lies with your business to collect outstanding money owed by your customers.
You can also set it up so the invoice discounting company is connected with your accounts receivable systems, so when your customer pays their invoice, the financing company automatically deducts their fee before you receive the balance.
With invoice factoring, on the other hand, you sell your outstanding invoices to a factoring company at a discount.
The company pays you a percentage of the invoice amount upfront, and then it becomes their job to collect the full amount from your customer.
Once the company collects the full repayment, they send you the difference, minus their fees.
|Invoice discounting||Invoice factoring|
|Also known as||Invoice financing or accounts receivable financing.||Accounts receivable factoring.|
|Financial structure||Loan/line of credit insured against your outstanding receivables.||The finance company buys your outstanding invoices at a discount and sends you a percentage upfront.|
|Collection||You collect repayment directly from your customers (although you can sometimes outsource this to the financing company).||The financing company collects the payment from your customers.|
The benefits of invoice factoring and invoice discounting
There are some major benefits to both invoice factoring and invoice discounting:
1. Quick access to cash upfront
Both the factoring process and discounting process are quick and simple, with monies provided within a couple of working days for approved invoices.
While initial setup can take between one and two weeks from the receipt of your factoring or discounting application, this is relatively fast compared to waiting on a conventional loan from a bank, which can often take months.
2. No debt
As factoring isn’t the same as a loan, it doesn’t add any pressure to pay back the money ASAP or deal with ongoing interest rates, which can negatively affect your business.
You don’t have to deal with monthly loan payments, and you can enjoy a clean balance sheet.
While discounting is a type of loan, it’s a relatively simple one that’s resolved as soon as your customer pays their invoice, so you don’t have to worry about paying it back for months or years on end.
3. Fair fees for factoring
The cost of factoring invoices is pretty reasonable, with advances and loans available for around the 85% mark and fees as low as 1-2%.
While fees will vary depending on a number of factors, such as your industry and how long it usually takes customers to pay, you can find out more by contacting the finance companies directly.
4. Flexible finance terms
Without any binding, long-term contracts, minimums, or maximums, you have a lot more financial flexibility.
You can decide how often and which invoices to factor or discount. As your sales increase, your access to funding also increases.
5. Freedom to spend as you please
Unlike some loans, invoice factoring and invoice discounting companies won’t tell you how you’re allowed to spend the funds.
You’re not obligated to buy a building or invest in a particular item.
6. Great credit isn’t needed
You don’t need to have great credit or be in business for many years to qualify for these services, either.
What matters is the rate and speed your customers pay their invoices.
7. Outsource some of the stress
You can also save a lot of time and reduce some of your in-house expenses by outsourcing the work of chasing customers for invoices using factoring.
Essentially, factoring companies can deal with the paperwork and hassle on your behalf.
Factoring and discounting can fund the growth of your company, too.
Carefully planned, you can use these methods to invest in equipment or workers at a time when investing is crucial, and thus strike while the iron is hot.
For example, by taking advantage of bulk order discounts from suppliers.
9. Reduce risk to your business
This is especially important for smaller businesses.
If even one customer is late in paying a large value invoice, this can have a knock-on effect on the overall health of your business.
But with invoice discounting and factoring, you can make sure you receive most of the invoice’s value straight away.
10. Make your own payments faster
Since you benefit from cash flow improvements, you can also settle your own repayment obligations faster.
You might even be able to obtain discounts for early repayment.
You don’t need to let your clients or customers know if you’ve entered into a discounting agreement with a financial institution, so you needn’t worry about the impact on your image or business reputation.
The risks involved in invoice factoring and discounting
Despite all the benefits of invoice factoring and discounting, there are also a few risks and drawbacks to consider:
1. Loss of control
Handing over control of something as sensitive as invoicing and cash collection can be an exercise in trust.
The factoring company assumes all responsibility for interactions in terms of invoicing and collecting payment, so a business’ image or interactions may be affected, especially if customers receive more forthright payment notifications than they’re used to.
There’s also a risk that customer service may suffer if the factoring team isn’t good at interacting with your client base.
2. To recourse or not to recourse
Recourse factoring is when the responsibility for invoice payment rests with the seller.
In this situation, the factoring company purchases the invoice under the understanding it will be paid.
If a buyer fails to pay within an allocated time frame, the factoring company can demand full payment plus the service charge from the seller.
With non-recourse factoring, the seller has no ultimate responsibility for payment of the invoices factored.
Because of the higher risk, non-recourse agreements are usually priced higher and may come with additional stipulations.
3. Customer perception
Sometimes, when businesses use a factoring company, buyers notice a change in the style of communications and payment requirements.
Having a third party handle factoring might also give the impression of cash flow challenges, which isn’t great for business.
4. Limiting your horizons
Sometimes, entering into an invoice discounting arrangement can make it harder to get other forms of finance.
5. Less profit
Obviously, going with a discounting invoice service means your overall profits will be reduced.
You won’t receive the full value of each invoice as some of it will go to your lender.
6. Habits can be hard to break
It can be a challenge to break away from invoice discounting arrangements since being able to quickly access payment can become a habit that’s hard to break.
Adjusting to a new reality where invoice payment dates are unpredictable can be tough for any business.
Leveraging invoice factoring and discounting for your business
Invoice factoring and discounting can be great resources when you need cash flow and feel confident in the finance company’s manner with your customers.
As long as you’re willing and able to go with a smaller profit in exchange for faster cash, it can be a really helpful system.
It’s advisable not to overuse them, though, as it could become a habit for your business.
Instead, treat them more as an occasional resource for when other financing systems aren’t available or appropriate.
Frequently asked questions
Invoice factoring is frequently used by small companies with limited budgets wishing to invest in their businesses, as well as enterprises that receive a lot of bulk orders.
Invoice discounting is often used by smaller businesses with smaller budgets who want to invest in their business and help it grow, as well as those that regularly receive bulk orders.
An example of invoice discounting is receiving a bulk order and hiring a financing company to pay a portion of the invoice upfront, so you don’t have to wait months to get your hands on the capital. When you eventually do get paid by your client, you’ll need to pay the financing company back, plus their service fee.
Invoice discounting works by lending your business money, which is backed by your accounts receivable. You then pay this back to the lender when the account is settled by your customer, plus the service fee.