Last editedDec 20202 min read
If your business needs an improved and more predictable cash flow, invoice finance could be a great option. There are several different types of invoice finance, including invoice discounting and invoice factoring. But when it comes to invoice discounting vs. factoring, do you know which comes out on top? Find out everything you need to know about invoice financing for small business with our helpful and comprehensive guide, right here. First off, what is invoice financing?
What is invoice financing?
Invoice finance is a way to monetise your company’s outstanding invoices. Essentially, your business is fronted a percentage of the invoice’s value by a third-party in return for a fee (typically 5% of the total value of the invoice). As such, invoice finance allows businesses in need of a short-term cash injection to get paid immediately, instead of waiting for days/weeks to collect payment from the customer. There are two main types of invoice finance: invoice factoring and invoice discounting. While the concepts are relatively similar, there are a couple of key differences to get your head around.
Understanding invoice factoring
Invoice factoring is a type of invoice finance that enables you to “sell” some of your outstanding invoices. In this scenario, a factoring company will pay you around 80-90% of the invoice amount immediately. Then, after the customers pay the factoring company for the full value of the invoice, they’ll pay you the remaining amount, minus their fee. Invoice factoring can be an excellent way for companies with a large number of outstanding invoices to navigate cash flow problems and improve revenue stability.
Understanding invoice discounting
With invoice discounting, the discounting company will lend your business a percentage of the money listed in the accounts receivable ledger. In effect, it’s like having an overdraft facility that’s secured against your accounts receivables. So, how does invoice discounting work? After you raise invoices for goods or services, the discounting company lends your business an amount commensurate to the full value of the invoices, minus a small percentage. Then, after you receive payment from your customers, you repay the loan, plus an agreed upon fee to cover the cost, interest, and risk (usually 1-3% of the total invoice value).
Invoice discounting vs. factoring
As you can see, invoice factoring and invoice discounting are both a means of gaining an advance against unpaid invoices. However, there are a couple of important differences to note when it comes to invoice discounting vs. factoring. Whereas invoice discounting is a loan secured against your outstanding invoices, invoice factoring companies actually purchase the unpaid invoices outright. This is an important difference because it provides factoring companies with credit control, which enables them to deal with customers directly. Although this means that you don’t need to worry about chasing up late payers, it could lead to negative perceptions of your business if the factoring company takes drastic measures.
It’s also worth noting that invoice factoring may be non-recourse, meaning that if you sell the invoice to the factoring company and the customer subsequently refuses to pay, you won’t be obligated to repay the money yourself. Invoice discounting is a loan, rather than a sale, which means that the money must always be repaid, and therefore non-recourse invoice discounting is relatively uncommon. Furthermore, unlike invoice discounting companies, factoring companies will run credit checks on your customers before agreeing to purchase your invoices. This can help you identify and discard bad payers, which should improve your ability to collect on your invoices in the future.
Choosing the right invoice finance method for your business
Generally speaking, invoice discounting is a riskier proposition for lenders than factoring. As a result, invoice discounting is mostly used by big companies with a steady and reliable customer base. By contrast, invoice factoring tends to be used by smaller companies due to its accessibility, rather than choice. Ultimately, the best invoice financing for small business solution depends on the needs and circumstances of your company.
We can help
GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.