Invoice financing is an umbrella term for arrangements that allows you to finance account receivables.
They are mostly used by small businesses to improve working capital and cash flow position by meeting short-term liquidity needs.
The two most used solutions are:
- Invoice discounting
- Invoice factoring
Invoice discounting and factoring are arrangements with the same end result – they release the funds tied up in your unpaid invoices. They are both executed in cooperation with a lending company that agrees to advance money against your outstanding invoice receivables.
However, the structure and the roles of the parties involved are different so you need to consider all the details before making a decision.
The key difference between invoice discounting and factoring lies in which party takes control of the sales ledger and responsibility for debt collection. With factoring it’s the lender (called factor), and with invoice discounting it’s your business.
What is Invoice Factoring?
Invoice factoring is an arrangement in which businesses sell their invoices to a third party (a bank or an independent factoring company) at a discount. Therefore, you typically lose control of credit management and debt collection, which may or may not suit your business.
This is an important consideration as you will lose control over a crucial part of your customer relationship as they will be aware of your arrangement with the factor. This may damage your relationship with customers because the incentive of a factoring company to maintain a good relationship with your customers is not as strong as yours.
But, on the other hand, this arrangement will free up your resources (human, time, etc) which had previously been employed in chasing payments and debt collection. These activities will now be undertaken by the factoring company.
How does Invoice Factoring work?
Most factoring companies will pay in two tranches.
The first is paid immediately and is usually around 60% and 80% of the value of the invoices. You get the cash, and the factor takes on the responsibility of credit control and chasing and processing invoice payments.
The second tranche is paid when your client settles the invoice. This amount is equal to invoice value minus any factoring fee. This means that the lender will collect payments from your customer and will transfer to your account the remaining amount minus their fee.
You should be aware that you will likely pay fees for every 30 days the invoice is unpaid after factoring. The fees vary between factors and are usually negotiable in the initial contract, but are typically calculated upon metrics such as credit standing of your clients and the size of the invoices.
You can choose between whole ledger factoring facilities where you assign whole sales ledger to the factor or spot factoring where you assign individual invoices. The latter offers more flexibility but usually comes at a higher fee.
What is Invoice Discounting?
Invoice discounting is another form of short-term borrowing against your outstanding invoices.
However, with invoice discounting, you maintain responsibility for your sales ledger, payment chasing and invoice processing.
In this type of arrangement, your customers are unlikely to be aware of your relationship with the lender. This allows you to maintain your style of communication and level of service which means your customer relationship will not be affected by this type of arrangement.
How Does Invoice Discounting Work?
You can usually get up to 85% of your invoice upfront from the lender. Then, when your customer pays the invoice, you’ll pay the lender back. It works in the way that fees and other charges are deducted from the remaining balance and transferred to the lender.
When is Invoice Financing Appropriate?
Invoice financing may be an appropriate form of short term financing if you are starting a business, growing a business or your business is facing some liquidity struggles. For more business growth financing or start-up funding options you can check our website.
The cash your business had already earned is tied up in your unpaid invoices, so invoice financing can help you bridge the gap between invoicing and actual cash inflow.
A typical candidate for invoice financing would be a business with customers on longer payment terms like 30-90 days. Terms such as these often create cash flow gaps that can seriously hinder even basic cash flow management like paying bills or payroll.
A business with a smaller number of clients and higher value per invoice is also vulnerable to late payments, so invoice financing can be appropriate in this case too.
Pros and Cons of Invoice Financing
The advantages of invoice financing would be reduced payment uncertainty and improved liquidity and cash flow management. This helps run and grow your business without incurring debt as the level of available funding increases with your turnover.
This convenience comes at a price but that’s the price you pay for immediate access to cash instead of waiting 30+ days for your customers to pay the invoices.
Which Form of Invoice Financing to Choose?
Your decision whether to choose invoice factoring or invoice discounting will depend on your business specific needs and your sales ledger management resources.
For smaller businesses that don’t have a finance department, the credit control services that come with factoring are one of the benefits as this will free up resources to focus on running the actual business, rather than dealing with payments and debt collection. But this will also mean that factoring is usually more expensive than invoice discounting.