Understanding financial terms can be overwhelming sometimes. Many people confuse “Invoice Finance” with other economic terms, like “Invoice Factoring” as well as “Invoice Discounting”. They are two different financial documents. If businesses can picture the difference, it helps them better manage their cash flow and make good financial decisions.

Invoice financing is a broad term, which encompasses a wide range of short-term financing options companies utilise to release cash tied up in unpaid bills. This category encompasses both invoice factoring and invoice discounting, each with its own unique benefits and processes. In this guide, we will help you understand the differences between invoice discounting and factoring, helping you make the right choice in different situations.

What is invoice factoring?

Invoice factoring, also known as debt factoring, is a way for companies to get short-term financing to speed up the cash flow process by selling their account received(i.e., Invoices) at discounted prices (factored). The factored invoices also help merchants with immediate cash flow to help pay for normal operating needs or expand the business and fill in some holes in their accounts payable.

Here’s how it works:

• An invoice is a billing document the merchant gives his customer after providing goods or services.
• Rather than waiting for the client to pay, the merchant sells that invoice at a discount (usually something like 70%-90% of face value) to a factor.
• The factor pays the merchant a sum upfront for their invoices minus an agreed-upon fee.
• The factor then collects the full payment from the customer.

Invoice factoring: Pros and Cons

Merchants need to consider the trade-off between the following advantages and disadvantages of invoice factoring before deciding if it has a place in their business operations:

Invoice factoring advantages:

Urgent cash flow:

Businesses use factoring to obtain quick cash, primarily for paying operational costs, capitalising on growth opportunities and filling in the gaps of outstanding receivables paid by customers.

Credit Management & Collection:

Factoring companies often collect on the behalf of the merchant, which means less work, time and stress on the business owners or managers, allowing them to concentrate fully on the main areas of the business. Certainly, this can be very beneficial for small organisations that are neither properly equipped nor have the time & resources to manage their accounts receivable.

Non-recourse:

This offers less risk for the merchant because if a customer fails to pay back, they are not obliged to pay anything to the factor. However, there is also recourse factoring, where the vendor is responsible for buying back unpaid invoices from the factor.

No collateral:

With invoice factoring, the invoices serve as collateral for the cash advance, so lenders do not require real estate or other valuable assets like traditional loans.

Invoice factoring disadvantages:

Costs:

Since factoring companies charge fees to perform their services, it is sometimes more costly than traditional financing. Older or more commonly known forms of factoring will often charge based on a percentage of the invoice value, which can add up over a period.

Customer interaction:

As the factoring company collects payments directly from customers, customer service could be impacted. They may not be comfortable about the involvement of a 3rd party in the payment procedure, which can further lead to trust issues.

Not all factoring can be done selectively:

Unfortunately, some factoring companies require businesses to factor in all their invoices rather than allowing you to choose which ones. This might result in increased costs, especially if the industry has to pay interest on accounts receivable to customers who settle early.

Creditworthiness of the customers:

This means that while invoice factoring companies set up their financing with the business invoices, they also evaluate the creditworthiness of a business’s customers. Financial factors may not approve every customer’s invoice due to a credit risk factor and will limit how much financing can be offered.

What is Invoice Discounting?

Invoice discounting is a secure loan in which monies are borrowed against the total value due to be paid by customers. 

Here’s the working mechanism:

• Initial Funding: The invoice discounter provides the merchant with an upfront payment of 70-90% of the invoice value.
• Risk Retention: A percentage (10-30%) is held back by the discounter to mitigate risks such as non-payment.
• Payment Collection: The merchant continues to collect payments from customers and updates the sales ledger accordingly.
• Advance Repayment: The merchant uses the collected funds to repay the discounter, covering the initial advance and any agreed fees.
• Fee Settlement: Fees, including borrowing costs, are settled based on the duration between the advance and repayment.
• Reserve Release: Once the advance and fees are repaid, the discounter releases the remaining reserve amount to the merchant.

Understanding Invoice Discounting Example: 

If you sell clothing to your customers on net terms, this arrangement permits clients to get the merchandise promptly. However, it puts off installments for 30 days or many times further. This delay can create significant cash flow problems for the merchant, who still has expenses to pay, such as rent, payroll, or inventory costs, while a large part of their working capital is stuck in payments yet to be collected.

This is when the idea of invoice discounting comes into play. Invoice discounts work just like a loan against unpaid invoices. The merchant takes out a loan against their sales ledger from a discounting company and receives up to 70%-90% of the invoice value as an advance.

A timely cash injection helps the merchant to accommodate the flow of business in a streamlined manner. However, hosting your API is not free. The discount invoice provider will charge a fee, usually 1-3% of the invoice value, in return for this service (as well as paying interest on any advanced money) and, if the client defaults on payments, to assist in recovering these expenses and reduce that risk.

Risks Involved in Invoice Discounting

If a buyer does not make the payment to the merchant following an agreement, it can lead to problems and ultimately be costly for the merchant and the invoice discounter. Actions and detailed results may differ based on the definitions within an invoice discounting agreement.

Recourse Agreement: Under a recourse arrangement, the merchant is usually liable to buy back any non-performing invoice from the invoice discounter. Here, the only solution is that the merchant needs to refund the full amount in advance, including charges and other expenses relating to this transaction/case, as an advanced tolling of knowing it will be charged at some point. 

Non-Recourse Agreement: In a non-recourse discounting arrangement, the invoice discounter generally accepts that non-repayment risk.  If the buyer defaults, the merchant would not be obligated to repurchase the invoice and suffer a loss usually taken by an accounts receivable discounter.

Reserve Application: If the invoice discounter has been reserving an amount, they are likely to apply this reserve against part of his outstanding balance. The amount in the reserve is usually only a fraction of how much you get from that invoice and may not be enough to pay for all your losses.

Invoice discounting: Pros and Cons

Invoice Discounting Advantages

1. Immediate Cash Release: Quickly access a substantial portion of the funds tied up in unpaid invoices, providing a cash boost.
2. Scalable Financing: Funding increases with the number of invoices you issue, unlike fixed-limit loans or overdrafts.
3. Optional Bad Debt Protection: Some providers offer the option to safeguard against bad debts through non-recourse invoice discounting.
4. Maintained Confidentiality: This financing option can be used without your customers knowing, keeping your financial strategies private.
5. Control Over Collections: You retain control over your credit management and customer interactions, managing collections internally.

Invoice Discounting Disadvantages

1. Associated Fees: There are costs involved with invoice discounting, but improved cash flow may help you secure discounts from suppliers.
2. Minimum Fees: Some services have mandatory monthly or yearly charges, though alternatives without these fees are available.
3. Security Requirements: Additional collateral, such as personal guarantees, may be required, though some providers offer more lenient terms.
4. Contractual Terms: Many agreements come with mandatory contract lengths and long notice periods, though more flexible options exist.
5. No Collection Support: Unlike factoring, invoice discounting requires you to handle credit control and collections yourself.
6. Set-Up Complexity: The initial process can be intricate and time-consuming, though this varies among providers.

Invoice Factoring vs. Invoice Discounting: The Primary Differences

As you have gotten a brief understanding of both, now, let’s look at the difference between invoice discounting and factoring:

	Invoice Factoring	Invoice Discounting
Ownership	Merchants sell the invoice outright to the factoring company. They buy and collect on the unpaid invoices themselves.	Merchants will still own the invoice. They just take some of the value of it from the discounter. Merchants are still responsible for collecting payments from customers.
Transparency	Customers are usually informed that the invoices have been factored in.	Discounting arrangements remain non-visible to customers
Collections	The important advantage of this system is that the company will handle your credit control and collect payments from customers so you can focus on growing.	The responsibility of following up on the pending customer payments lies on merchants.
Cost	This additional service increases the fee again because of the credit control and risk assumption.	Merchants typically pay lower fees as they own and facilitate collections.
Suitability	They are typically seen among smaller merchants or those with irregular customer payments.	Typically used by mid and big merchants with good customer relationships and trusted payment cycles.

Which one should you choose?

Factoring and discounting are invoice financing tools that provide working capital to businesses looking for liquidity boosts to facilitate their growth. The immediate liquidity and the credit management outsourced from invoice factoring offer an interesting solution to companies that want to alleviate all of the headaches related to the accounts receivable, unlike invoice discounting, which is less transparent and offers a discreet cash advancement, allowing the merchant to have more control over communication with customers and collections. By understanding their differences, merchants can make business decisions that align with their everyday operations and financial strategies.

Finally, remember that invoice financing is a means to grow your business – not an answer for underlying cash flow problems. Use it as a component of an overall financial strategy.

Top Accountants Are Always At Your Service

Are you looking for expert advice on invoice discounting vs. factoring? Contact TaxCan Accountants and Cangaf Ltd. today for more information about which invoice finance options suit your business. Let our experts assist you with invoice factoring and discounting capabilities.

Our experts can help business owners improve their cash flow and financial operations. They help keep your business running with money in the bank. Start looking into invoice financing options today and take control of what your financial future holds.

Contact Details:

CANGAF Accountants
235 Tonge Moor Road, Bolton BL2 2HR
Email: info@cangafltd.com
Phone: 01204 859315

Let CANGAF Accountants manage your finances while you focus on excelling on the pitch.