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What is the difference between invoice discounting and factoring?

Cash flow has always been a key priority for businesses – but, in today’s trying economic climate, it has perhaps never been more important.

This has brought about a huge rise in the popularity of invoice financing solutions, which allow businesses to unlock capital they have tied up in outstanding customer invoices.

In simple terms, invoice financing allows businesses to get paid an advance of anything between 80% – 95% of their overall invoice value. This can give businesses the financial flexibility they require to meet significant short-term cash demands, such as tax bills, or – even better – empower them to invest in growth.

There are other benefits, of course. These include:
* the ability to secure funding without requiring other assets to be used as collateral.
* the scalability of funding (the amount of available funding increases with your turnover.)
* the ability to pay supplier invoices promptly, which opens up the possibility of negotiating early payment discounts.
* the fact that invoice finance solutions are usually very competitively priced compared to other forms of borrowing.

Buyer beware! There are two different types of invoice finance, which sometimes causes confusion. These are called invoice discounting and factoring.

We’re often asked what the differences are between these two. In this article, we’ll take a look at how they differ.

Common Ground:
First, let’s explore the similarities. Both solutions are alike in the sense that they involve a third party, usually a bank or similar financial institution, agreeing to ‘buy’ your invoices, and advancing you a percentage of their face value.

Fundamentally, the differences between these types of invoice finance lie in how customer payment is collected.

Factoring

With factoring, the party who ‘buys’ your invoices takes control of your sales ledger – and assumes responsibility for collecting payment from your customers. They essentially take over the credit control function of your business.

The customers settle their invoice directly with the factoring company.

The fact that the factor is so actively involved in collecting and processing payments, of course, means that the financing arrangement you have in place is disclosed to your customer.

This isn’t necessarily a bad thing, but it is worth considering.

Pros and cons:

+ Because they are responsible for collection, the factor company usually assumes the risk of non-payment by your customer.

+ The fact that a credit control and collection service is usually ‘built-in’ to a factoring agreement means you can focus your resources on other areas of your business.

– Your customer will know about the factoring agreement. Some businesses prefer to keep the arrangement confidential and your customers may actually prefer to deal with you directly.

– Since your invoices essentially become assets of a third party, you can’t use them as collateral to secure alternative funding. (Of course, other types of collateral will still be available to you.)

Invoice Discounting

With invoice discounting, you retain control of your sales ledger, and continue to collect customer payments in line with your usual processes.

As your customers pay you directly, there is no need to disclose the financing arrangement you have in place for their invoices.

However, because the funding party has no control over collection, you typically bear some or all of your non-collection risk.

Pros and cons:

+ Since there is no change to the customers’ experience (and to your commercial contract with your customers), your funding contract with the third party financier can be kept completely confidential and your customer relationships are unaffected.

+ Because the funding party does not have to bear the costs involved in collecting payments, and usually has lower risks associated with payment default, invoice discounting is typically a cheaper form of finance than factoring.

– Since your invoices essentially become assets belonging to a third party, you can’t use them as collateral to secure alternative funding. (Of course, other types of collateral will still be available to you.)

– You will need a strong collections track record and a low default rate for this type of finance

Which solution is best for you?

Choosing which option works best for you typically comes down to two considerations: business size, and management resources.

For small to medium sized businesses and startups, factoring is usually a popular option. This is simply because of the built-in collection and credit control facility, which allows you to reduce or even eliminate investment in your accounts receivable processes and software. It also frees up time, which is invariably in short supply for small business owners who often have dozens of other priorities.

Invoice discounting is used more by larger companies requiring capital for growth. The larger sales volume enjoyed by these companies means that an invoice discounting agreement can give them a substantial cash injection at a comparatively low interest rate. With established credit-control processes in place, there is often no need for this function to be outsourced to a third party.

However, every business is different – and we’d be more than happy to discuss your unique requirements. You can call us on +44 (0) 2078594742 or email us at contact@giifinance.com.

Also, don’t forget to check out our Complete Guide to Invoice Discounting for more information about this invoice finance solution.

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