Invoice Discounting vs. Invoice Factoring - Which One Is Better?

You may consider invoice finance if you want to improve your cash flow. Invoice financing includes invoice discounting and invoice factoring.

 

It is common for businesses to sell goods and services on credit to large customers, such as wholesalers and retailers. The customers do not have to pay for the purchased goods immediately. But instead, they receive an invoice that shows the amount due and the due date for payment. The provision of such credit to customers ties up the funds that businesses may otherwise use to expand and invest. To finance slow-paying receivables or ensure short-term liquidity, companies may choose to finance their invoices.

In the U.S. alone, over 30% of small businesses are facing, or expect to experience, late or unpaid invoices, which have detrimental effects on company investments, supplier payments, and payroll. Fortunately, invoice financing can help you avoid these difficulties. How does invoice financing work?

 

What is Invoice Financing?

Invoice finance allows your company to monetize its outstanding invoices. Essentially, a third-party front your company a percentage of the invoice value for a fee (typically 5% of the invoice value). Therefore, invoice financing allows businesses that require a short-term cash injection to get paid immediately rather than waiting days or weeks for the customer to pay their invoice. Invoice discounting and invoice factoring are the two most common types of invoice financing. Though the concepts are similar, some differences are worth understanding.

 

What is Invoice Discounting, and How Does it Work?

With invoice discounting, a discounting company loans your company an amount based on your accounts receivable ledger. It is like having an overdraft facility secured by your receivables.

Your business raises invoices for goods or services. A discounting company lends you an amount comparable to the invoices’ total value, less than a small percentage. Once you receive payment from your customers, you repay the loan, plus a fee of about 1-5% of the total invoice value to cover costs, interest, and risk.

 

What is Invoice Factoring?

As a form of invoice financing, factoring allows you to sell some of your outstanding invoices. In factoring, a company sells one or more accounts receivable invoices due on credit terms to a financier, known as a factor, for a lower price than what they are worth. The business receives approximately 80% to 90% of the invoice amount. Once the factor has collected the entire invoice amount, the company takes the rest of the balance, less the factor’s fees. A factoring fee can be high and include a percentage of the invoice value, service charges, origination fee, and credit check fee.

Factoring is a helpful tool to boost a cash flow when a company’s short-term debts exceed cash on hand, in which case it may try to sell invoices to get funds from a factor immediately to pay its short-term debt.

 

Invoice Discounting versus Factoring: What is the Difference?

Invoice discounting and factoring offer funding to businesses that need cash to accomplish their goals, such as making payroll, paying their vendors, or purchasing more inventory. Yet they differ in one essential respect – invoice discounting is a loan, whereas invoice factoring is a sale.

Businesses that use invoice discounting receive a loan from a bank or a finance company that lends based on the value of outstanding invoices. Your customers will not know that you have taken out a loan on their invoices. You will be required to make repayments just like with any other loan, and your business will continue to collect payments from your customers as usual. Worthing to note that if your customers discover you use their invoices to secure a loan, they may believe that your business is suffering, which might harm future business relations.

On the other hand, with invoice factoring, your invoices are owned by the factoring company, which collects payment from your customers. Since the factoring company collects payments from the customers, the customers will know this financial arrangement, which might damage your company’s reputation.

 

Advantages and Disadvantages of Invoice Discounting

Pros:

✅ You can increase your cash flow, pay your suppliers and employees, or use the money for other business activities.

✅ Invoice discounting allows you to release cash locked in customer invoices for an extended period.

✅ You will maintain credit control and the collection process, and your customers will be unaware that this type of financing is employed.

✅ Using invoice discounting to get loans is faster than traditional business loans.

✅ Invoice discounting offers unsecured business loans on your invoices, thus posing no risk to your company’s movable assets.

 

Cons:

✅ One disadvantage of invoice discounting is the cost to be incurred. Businesses may experience short-term reductions in profits on invoices used for invoice discounting. But the prospect of growth and early access to cash offset this disadvantage.

✅ Invoice discounting provides funding based on the current accounts receivables and is therefore not ideal if a company requires a specific amount of business financing.

 

Advantages and Disadvantages of Invoice Factoring

Pros:

✅ The main advantage of factoring invoices is that it quickly releases funds, which improves cash flow almost immediately.

✅ Outsourcing the company sales ledger can be a cost-effective method of freeing up their time to manage the business.

 

Cons:

✅ The cost will cause a decrease in the business profit margin for each order or service.

✅ Factors handle the credit control and collections process when a factoring arrangement is in place, and your customers will know this type of financing is employed. Your customers’ perception of you depends on how the factor deals with them. Remember to use a reputable company that will not harm your reputation.

✅ To end a factoring arrangement, you will have to repay any money that has been advanced to you by the factor if the customer has not yet paid the invoices. It may require some planning in advance on your part.

 

Choosing the Right Invoice Finance Method for Your Business

The optimal invoice financing solution will depend on the needs and circumstances of your business. Large, established companies with a stable customer base mostly used invoice discounting. In contrast, small companies typically use invoice factoring because of its accessibility rather than choice. 

 

Conclusion:

Small businesses that require a quick cash injection but do not want to wait for lengthy approval processes may seek invoice discounting or invoice factoring as an alternative to bank loans. There are, however, significant differences between the two. It is vital to consider both their pros and cons.