Invoice Discounting vs Invoice Factoring: Debt Collection, Sale and Ledger Maintenance

What is Invoice Discounting and Invoice Factoring?

Invoice discounting involves a business borrowing money against its unpaid invoices while maintaining control over its sales ledger and collections, while invoice factoring entails a business selling its unpaid invoices to a third party, who then takes on the responsibility of managing the sales ledger, collecting debts, and maintaining client relationships.

Unravelling the Finance World: Invoice Discounting vs Invoice Factoring

In the ever-complex world of business finance, a number of concepts and practices can appear daunting for those new to the game. Among these, two methods of short-term finance that often get confused are invoice discounting and invoice factoring.

Both methods are used by businesses to manage cash flow by leveraging their unpaid invoices. Although they might seem similar on the surface, they serve different needs and present different advantages and disadvantages.

A Brief Overview: Invoice Discounting and Invoice Factoring

Let’s start by understanding what these terms mean.

Invoice Discounting

Invoice discounting is a self-service form of finance where a business borrows money against its outstanding invoices.

This financial arrangement allows businesses to retain control over their sales ledger, customer relationships, and the collection of payments.

Typically, the lending institution provides 80-90% of the total invoice value immediately, with the rest, less any fees, being paid once the client has paid the invoice in full.

Invoice Factoring

On the other hand, invoice factoring involves a business selling its outstanding invoices to a third party (the factor) at a discount.

In contrast to invoice discounting, the factor assumes responsibility for managing the sales ledger, collecting debts, and maintaining client relationships.

The business receives an initial advance, typically around 70-85% of the invoice value, with the remainder (minus fees) given once the customer pays.

Key Difference between Invoice Discounting vs Invoice Factoring

Now that we understand these two financing forms, let’s delve into their key differences.

Control over Collection

Arguably, the most significant difference between invoice discounting and invoice factoring is who maintains control over the invoice collection process.

In invoice discounting, the company retains control over the management of its sales ledger and collections, which can be preferable if the business wants to maintain direct relationships with its customers.

Conversely, the factoring company takes over the collection process in invoice factoring. Outsourcing might benefit smaller companies or those without the resources to manage their credit control effectively.

Confidentiality

Invoice discounting is usually confidential, meaning your customers may not know about your financial agreements.

This factor is crucial for companies that want to maintain a particular image or avoid revealing their financial arrangements to clients.

Invoice factoring, however, is generally not confidential, as the factoring company handles invoice collection.

Your customers will know that a third party is involved, which may or may not affect your business relationships.

Business Size and Resources

Invoice discounting is often more suited to larger, well-established businesses with robust financial processes. These companies usually have the resources to manage their collections and debt recovery procedures.

On the other hand, invoice factoring can be more appropriate for smaller businesses or startups.

The reason is, these companies might lack the resources to chase unpaid invoices or might prefer to focus their energies on other areas of business growth.

Pros and Cons

Like all financial decisions, invoice discounting and invoice factoring have pros and cons that should be considered before deciding on the right solution for your business.

Invoice Discounting Pros and Cons

Pros:

1. Greater control over the collection process.
2. Confidentiality is maintained with clients.
3. Immediate cash flow injection.

Cons:

1. The company is still responsible for chasing unpaid invoices.
2. It might be more expensive due to the higher risk for the lender.
3. Not suitable for businesses without an effective credit control process.

Invoice Factoring Pros and Cons

Pros:

1. The factoring company handles collections, freeing up your resources
2. Immediate access to funds
3. Potential access to additional services like credit protection

Cons:

1. Potential damage to customer relationships as a third party collects debts
2. It may be viewed negatively by others in your industry
3. Typically, it costs more than traditional lending due to the services involved.

Invoice Discounting vs Invoice Factoring

Because invoice discounting requires the business to maintain control over invoice collections, having these resources in place is crucial.

This form of financing allows large organisations to benefit from immediate access to funds while maintaining direct relationships with their customers and ensuring that their financial arrangements remain confidential.

Conversely, invoice factoring is often more appropriate for smaller businesses, including startups and SMEs.

These businesses might not have the resources or capacity to chase unpaid invoices effectively and might prefer to dedicate their time and efforts towards other areas of business growth.

Can I Use Both Invoice Discounting And Invoice Factoring Simultaneously?

Using invoice discounting and invoice factoring simultaneously within the same business could be complex and potentially inefficient, but it is not entirely impossible.

The feasibility largely depends on your business circumstances and the financial institutions’ agreements.

Typically, a company would opt for one or the other based on its needs, resources, and strategy.

For instance, larger companies with robust credit control departments might prefer invoice discounting to maintain control over their customer relationships, while smaller businesses or those wanting to outsource their credit control might go for invoice factoring.

With invoice discounting, the process is typically confidential. Your customers do not need to know about the financial arrangement because your business retains control over the collections process.

You continue to invoice your customers as usual, collect payments, and manage the sales ledger, thereby maintaining a direct relationship with your clients.

The finance provider is essentially invisible to your customers, acting only as a silent backer to improve your cash flow.

For businesses that prioritize maintaining a certain image or discretion about their financial dealings, invoice discounting can be the preferred choice.

Conversely, invoice factoring is generally not confidential. This arrangement involves a third party, the factoring company, taking over your sales ledger and debt collection processes.

Since the factor is directly involved in collecting payments from your customers, they are aware that you’ve engaged a third-party service for your invoice management.

Some businesses might worry that this could affect customer relationships or perceptions, as it signals a third party’s involvement in financial matters.

However, factoring is a commonly accepted business practice, and most customers understand its use as a finance management tool.

What Happens If An Invoice Is Not Paid Under An Invoice Discounting Or Invoice Factoring Agreement?

The treatment of unpaid invoices under both invoice discounting and invoice factoring agreements depends on the terms set out by the financial institution and whether non-recourse arrangements are in place.

Since the business maintains control of the sales ledger and the debt collection process in invoice discounting, it is typically responsible for pursuing any unpaid invoices.

If a customer fails to pay an invoice, the business might have to repay any funds advanced against that invoice by the finance provider.

However, if the agreement includes non-recourse invoice discounting — a less common but available option — the finance provider absorbs the credit risk, and the business is not liable for unpaid invoices.

In invoice factoring, the factoring company takes over the collections process. If an invoice remains unpaid, the treatment depends on the factoring agreement type.

In recourse factoring, the most common type, the business is liable to repay the factoring company for any unpaid invoices after a set period.

On the other hand, with non-recourse factoring, the factoring company absorbs the credit risk, insulating the business from the impact of unpaid invoices.

However, it’s crucial to understand that non-recourse agreements typically cover credit risks such as insolvency of the customer but might not cover disputes over goods or services.

They also usually come with higher fees due to the increased risk the finance provider takes.

How Are The Fees For Invoice Discounting And Invoice Factoring Determined?

The fees for invoice discounting and invoice factoring depend on several factors, which typically include the volume and value of invoices, the creditworthiness of your customers, the agreed-upon credit period, and the level of service provided by the financier.

• Invoice Discounting: In the case of invoice discounting, the primary fee is the discount charge, similar to the interest charged on a traditional loan.
  • This is usually calculated as a percentage of the invoice value and is often tied to a benchmark rate like LIBOR or the prime rate, plus an additional margin. Some providers may also charge a service fee, which covers the administration costs of managing the arrangement. This could be a flat annual or monthly fee or a turnover percentage.

• Invoice Factoring: Invoice factoring typically involves two main fees. The first is the factoring fee, which covers the cost of the service, including managing your sales ledger and collecting debts. This fee is usually a percentage of the invoice value.
  • The second is the interest charged on the money advanced to you, similar to invoice discounting. Additionally, there might be setup fees, administration fees, and potentially minimum volume fees.

Conclusion: Invoice Discounting vs Invoice Factoring

Ultimately, the choice between invoice discounting and invoice factoring depends on your business needs, resources, and overall objectives.

Invoice discounting could be better if you value maintaining direct customer relationships and have effective credit control processes.

However, invoice factoring could be the right choice if you want to free up resources spent on debt collection or need additional services like credit protection.