On this page, we’re going to help you figure out the key differences between invoice factoring and invoice discounting. The goal here is to help you find the most suitable short term finance solution for your business.
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What is Invoice Factoring?
Factoring is a type of short-term accounts receivable financing, where you effectively ‘sell’ your outstanding invoices to a third-party commercial finance company. Sometimes, there’s a gap between when you finish a job and send an invoice and when the client returns payment and this is where invoice factoring can add value.
The terms of factoring deals are different in many situations, but most factors advance businesses between 60 and 80 percent of the value of the invoices. You get your cash, and the factor takes on the responsibility for getting payment from those customers, managing the credit control of the business, and processing invoice payments. This means that your customers will be aware of your relationship with the factor. In other words, they will know that you are using invoice factoring as a short-term financing method.
What is Invoice Discounting?
Like business invoice factoring, invoice discounting is a form of short-term borrowing against your outstanding invoices. It is usually used to help improve a company’s working capital and cash flow position. With invoice discounting, you maintain responsibility for your sales ledger, payment chasing, and invoice processing. As a result, your customers are unlikely to be aware of your relationship with the lender.
What are the Differences between Invoice Factoring Vs Discounting?
Factoring and invoice discounting both involve borrowing against your debt. But there are some big differences in how they work:
Visibility and Control
- With factoring,the finance company takes over the management of your sales ledger and credit control process. They also actively chase customer payments on your behalf, meaning you can do away with the time and cost of credit checking your customers, which is especially important if credit control has been poor in the past.
- With Invoice discounting you get to manage your own sales ledger and collect payments yourself. Because you retain control of the process, your customers should be unaware of the invoice discounting agreement. you get to manage your own sales ledger and collect payments yourself. Because you retain control of the process, your customers should be unaware of the invoice discounting agreement.
Adjustments to advances and funds available
- With factoring you are given advance funds for individual invoices. Any adjustments to the funds you receive are made on a day-to-day basis.
- With Invoice discounting an invoice discounter does not manage your sales ledger. Normally, you will have 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 to the funds that are available to you. So, rather than small daily adjustments, invoice discounting can lead to larger adjustments. These can be more difficult to deal with.
Risks of Factoring vs Invoice Discounting
- Factoring is less risky for the lender because the factor manages the credit control and collection processes. Acceptance is virtually guaranteed. This is why factoring is a popular form of finance for businesses that are hard-up or threatened with insolvency.
- Invoice discounting is riskier for the lender because there is no direct contact with your debtors. They do not have control. Therefore, discounters typically only lend to businesses with a turnover of £100,000+ and a positive net worth on their balance sheets to reduce the risks. Some invoice finance companies may focus on the quality of the debtor book and even larger turnover to lessen the risks. With this increased security, businesses typically get better rates and advances and you can worry less about contractual ties, personal guarantees, or debentures.
Advantages and Disadvantages of Invoice Factoring Vs Discounting
Both of these mean a fast boost to your cash flow. Thanks to the differences between the two, though, there are distinct advantages and disadvantages associated with each.
Factoring: The pros…
- The finance company will look after your sales ledger, manage the credit control process, and chase payments, freeing up your time to manage the business.
- Excellent credit checking processes mean you are more likely to trade with customers that pay on time.
- Working with a factoring company can sometimes help you negotiate better terms with your suppliers.
Factoring: The cons…
- Your customers may prefer to deal with you directly.
- The presence of a factor may impact the impression the customer has of your business, particularly if they are dealt with badly by the factor. You may even lose them.
- The additional services provided by a factor do come at a cost. The management fees for invoice discounters are typically between 0.2 and 0.5 percent of turnover. A factor can ask for anything from 0.75 to 2.5 percent of turnover.
Invoice discounting: The pros…
- Invoice discounting can be arranged confidentially, so your customers will have no idea you’re borrowing against their invoices.
- You keep managing your own credit control and debt collection for customer accounts, helping you to build and maintain closer relationships with your customers.
- Invoice discounting is cheaper than factoring.
- There is likely to be less risk to the director with the more modern providers.
Invoice discounting: The cons…
- You will need a strong and established credit collection process in-house to be accepted by an invoice discounting lender.
- Invoice discounters only tend to work with businesses with a turnover of £100,000 and a positive net worth on their balance sheets.
- Some businesses end up relying on invoice discounting as a source of cash and cannot leave the arrangement without a negative impact on their sales and operations.
Which Industries Favour Factoring and Invoice Discounting?
Any business which invoices from 30-90 days would be a typical candidate for accounts receivable financing. Equally, a business which has a smaller number of clients owing a higher value of invoice means there is a particular cash-flow vulnerability to late payments.
Certain industries tend to utilise invoice finance more than others, including:
Which is right for you?
Which is the better accounts receivable financing option, factoring or invoice discounting? It depends on the nature of your business and its particular needs. Your business’s size and ability to effectively manage your sales ledgers are also key considerations.
If you have a smaller business that has had problems with credit control and collecting payments in the past, for example, factoring is likely a better option. Generally speaking, factoring can be a more solid solution for these businesses because of the increased credit control the service provides. However, it will take a slightly bigger bite out of your profit margins and your provider may insist on credit insurance (Insuring against Bad debt).
Invoice discounting is more common among larger businesses with lots of resources though this is changing as the model develops. They already have an established and proven credit control processes. Invoice discounting is also a better solution if you want to protect key customer relationships. Check out credit insurance too.
Find out more
At Business Expert, we provide a truly impartial invoice finance comparison tool which obtains real time updates so you get the best deal available. You can compare the service levels and costs of invoice finance providers and get your selected providers to compete for your business. What’s not to like?