Invoice Discounting vs Factoring
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A healthy cash flow is the lifeblood of a successful business. But in reality, most enterprises face payment delays at certain times.
Because late invoice payments can create financial risks, businesses often use specialist invoice finance as part of their contingency planning.
There are two main methods of invoice financing: invoice discounting and invoice factoring. They sound similar, but they work in different ways.
Let’s take a closer look.
What is invoice finance?
Invoice finance is a specialist form of business finance. It lets businesses quickly unlock cash tied up in unpaid invoices, so they don’t need to wait for 30-90 days for clients to pay what they owe.
By providing fast and easily-accessible solutions for cash flow issues, it also removes the need for traditional business lending methods, which typically have longer timescales and fewer flexible features.
Why do businesses need invoice finance?
When businesses face multiple unpaid invoices, their cash flow takes a hit. This can lead to bigger issues such as:
- Hampered growth (an inability to invest or grow the workforce).
- Reputational issues (from the knock-on effects of delayed payments to suppliers, staff etc.)
- Organisational issues (unpaid supplier invoices may mean the operation grinds to a halt.)
- Depleted financial reserves.
- Risk of insolvency if the situation worsens or persists.
What are the types of invoice finance?
There are two main types of invoice finance for businesses to consider:
- Invoice Discounting and
- Invoice Factoring (also known as debt factoring)
Let’s assess the features and benefits of each in turn.
What is invoice discounting?
With invoice discounting, the business doesn’t have to wait for invoices to be paid.
Instead, it sells unpaid invoices to a finance company or bank to receive immediate cash flow, at a discounted rate of the invoice’s value.
Invoice discounting is a confidential form of invoice finance, and the customer never knows that a third-party finance company is involved. The business retains control of its invoice collections.
In effect, invoice discounting is like having a business overdraft, or a rolling base of short-term loans secured against your business’s accounts receivable ledger.
How does invoice discounting work?
Here’s how invoice discounting works:
- The business generates a customer invoice for goods or services provided.
- Rather than waiting for that invoice to be paid, the business then forwards the invoice to its invoice discounting lender.
- The lender verifies the validity of the invoice, then advances funds quickly, at a discounted rate. For example, it might pay the business 90% of the invoice value within 24 hours.
- The customer pays the invoice amount to the business without realising that there is a third-party involvement. Note: the business remains the credit controller.
- When the payment clears, the business repays the loan to the invoice discounting firm, plus a fee that covers interest, risk, and costs. (Typically 1-3% of the total invoice value.)
Sometimes, customers pay into a trust account that the invoice discounting provider owns, but manages in the business’s name. This maintains confidentiality but reduces the lender’s risk of non-payment.
What are the business benefits of invoice discounting?
- Speed – rapid access to the cash in your accounts receivable ledger, faster.
- Confidentiality – the customer never knows that the arrangement is in place.
- Control – it allows the business to stay in control of its business sales ledger, invoicing processes, and customer relationships.
- Lower fees, typically, than invoice factoring.
- Simpler and cheaper than applying for a bank loan, and has a higher chance of approval. Also, typically does not require extra collateral.
- Provides a predictable revenue stream, making business forecasting and planning easier.
- Scalable, as the business grows.
What are the downsides of invoice factoring?
- Possible impact on business creditworthiness
- It may not be available to smaller or newer businesses.
- Relatively high costs, compared to in-house collection processes
- Potential impact on customer relationships
- Limitations on accessing additional financing
Which businesses are suitable for invoice discounting?
Invoice discounting tends to be used by:
- Established companies with in-house credit controllers and strong internal systems
- Businesses that want to directly manage their customer relationships.
What is Invoice Factoring (Debt Factoring)?
Invoice factoring, or debt factoring, is a more hands-on approach to invoice finance. With this approach, the business hands over its sales ledger to a factoring company. The factoring company will manage it and chase payments.
How does invoice factoring work?
Here’s how invoice factoring works:
- The business issues the invoice and forwards a copy to its factoring service provider.
- The factoring company advances the business around 80-95% of the invoice (depending on terms)
- The factoring company then follows up directly with the customer and collects payment from them, taking this process on directly.
- When the customer has paid the invoice, the factoring company sends the business the balance, less applicable fees.
Note that the fees of invoice factoring are typically higher than for invoice discounting, because the finance provider delivers more for the service.
What are the business benefits of invoice factoring?
- Faster cash flow, with rapid access to working capital.
- Outsourced credit control frees up resources and time.
- Better risk management, as most invoice factoring companies offer automatic protection from bad debts.
- Potentially easier to set up than an invoice discounting arrangement, with less stringent requirements. Requires no financial security, unlike traditional business loans.
- Hands customer relations over to a named third-party provider.
- Invoice factoring can be non-recourse (if the customer doesn’t pay an invoice you sold to the factoring company, your business isn’t liable for it.) It’s a more expensive service, but some businesses choose this route for peace of mind.
- Scalable as the business grows.
What are the downsides of invoice factoring?
- Higher costs (fees of 1-5% of the invoice value)
- Loss of control over business relationships (the factoring company takes on collections)
- Possible reputational damage if clients view factoring negatively
- Likelihood of long-term contracts if customers continue to delay payments, leading to extra costs.
Which businesses are suitable for invoice factoring?
Invoice factoring is particularly popular with:
- SMEs with small internal finance teams
- Firms that struggle with high invoice volumes and late payments from clients.
- Businesses with a turnover of less than £100,000, that might be ineligible for invoice discounting services.
How to choose the right form of invoice finance
Although invoice discounting and invoice factoring both seem similar (providing a cash flow advance against unpaid invoices), they work differently.
- Business lenders offer invoice discounting as a specialist form of debt finance.
- Invoice factoring companies buy unpaid invoices at a discount, then collect the funds owed directly.
The right form of invoice finance will depend on your business, particularly its size, operating structure, resource availability, and the degree of control you want to maintain with customers.
As a general rule:
- Invoice factoring may be preferred if your business wants help with collections, a more hands-off approach with customers, and a fast way to access payment funds.
- Invoice discounting will be better if your business wants to retain its customer relationships in-house and has a strong in-house credit control team, with robust processes.
What are the costs of invoice finance?
These will vary by lender and by your chosen form of invoice finance, but expect to see these types of fees and charges, and be sure to compare offers carefully on a ‘like for like’ basis.
- Discount margin, or interest charged on advanced funds. Typically 0.5% to 4% or more.
- Service fees: usually charged as a percentage of the invoice value or business turnover.
- Administration and legal fees: usually one-off set-up costs.
- Other possible fees such as termination fees.
It’s smart to use the services of a financial broker to identify which forms of invoice finance might be best for your situation and to see which offers might best suit your needs.
Questions to ask a broker about invoice finance
Firstly, make sure your finance broker is FCA regulated, so you know you’re dealing with a qualified, legitimate, and impartial brokerage service (like ABC Finance – we are also voluntary members of FIBA – The Financial Intermediary and Broker Association – which exists to raise standards in the finance industry).
Take the time to ask plenty of questions about invoice finance before you decide on the right approach for your business. Key areas to clarify are:
- Will invoice finance benefit my business, and which form is best for me?
- How much will the recommended invoice finance service cost my business? How is that cost structured?
- What flexibility is built into invoice finance solutions? Note that some newer services offer flexible solutions, where businesses can send invoices at busy or ‘crunch’ periods when they need extra help, rather than 100% of the time.
- Will I need bad debt protection? Also known as trade credit insurance, this can usually be bought separately if it isn’t factored into a service contract.
Final thoughts on invoice finance to handle late payments
Late payments may be a fact of business life, but that doesn’t mean you need to risk cash flow issues.
Invoice discounting and factoring are two types of invoice finance that can help your business’s cash flow without needing a traditional business loan.
By understanding both types of invoice finance available and the suitability of each for your business, you can shore up your operation with reliable access to cash flow when you need it most.
