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Companies that sell to manufacturers, wholesalers, retailers and distributors, as well as many service-providing companies, bill customers with invoices rather than accept cash and credit cards at the point of sale. Invoices typically have defined due dates, from immediate to 90 days. Some companies may offer a reduction in the amount due for payment before the due date. However, they all involve waiting to get paid, which can put a strain on your company's cash flow. Invoice financing, which includes invoice factoring and invoice discounting, is often the solution to getting paid quicker and provides immediate cash secured by your unpaid invoices.
What is Invoice Factoring?
A business can turn to invoice factoring to collect an advance on unpaid invoices from a factor provider (the factor). The business sells the invoices to the factor for an advance of about 70% to 90%. When an invoice is collected, the factor turns over the remaining portion of its value, minus a fee.
For example, Bob's Wholesale Meats delivers $10,000 in choice carcasses to Ottomanelli Butcher Shop and prepares an invoice in its computer system for payment due in 30 days. The same day, Bob's sells the invoice to a factor company and immediately receives $8,000. The factor, rather than Bob's, sends its own invoice to Ottomanelli for payment. Twenty-nine days later, Ottomanelli sends a check to the factor company for $10,000. The factor company then sends a payment of $1,600 to Bob's, retaining $400 as its factoring fee. Bob's ends up collecting 96% on its original invoice, paying 4% to the factor provider.
How Does Invoice Discounting Work?
Invoice discounting is very similar to invoice factoring. The biggest difference is that collection remains the responsibility of the business issuing the invoice rather than the factoring provider. The business sends the invoice directly to its customer, and payments typically go into a trust account controlled by the factoring company. The factor shares information with the business's accounting system and forwards a cash advance when the business issues the invoice. When the customer pays into the trust account, the factor pays the remainder of the invoice value to the business, retaining a fee for its services.
In our example, Bob's creates and issues the invoice electronically to Ottomanelli for $10,000. The factor company, which interfaces with Bob's accounting system, recognizes the invoice issuance and wires $7,500 to Bob's business account. When paying the invoice 29 days later, Ottomanelli sends an electronic check to a bank account that is, unbeknownst to Ottomanelli, controlled by the factor company. The factor then sends $2,250 to Bob's business account, keeping $250 as its fee. Bob's receives 97.5% of the invoice amount, paying 2.5% to the factor company for its services.
Invoice Factoring vs Discounting: Which is Better for Your Business?
The following table summarizes the differences between invoice factoring and discounting.
|Collection||The factoring provider is responsible for collecting the invoice.||The business issuing the invoice is responsible for its collection.|
|Confidentiality||Customers know the business is using a factor.||Customer is unaware the invoice is being factored.|
|Company size||Factoring preferred for smaller companies because factors want control of collection to reduce risk.||Discounting used by larger companies with higher turnover and more creditworthy customers, which helps mitigate risk.|
|Fees||About 1.5% to 4.5% of invoice value.||About 1.5% to 2.5% of invoice value.|
|Initial advance||70% to 90%||70% to 90%|
|Flexibility||Business can select which invoices to finance.||Business usually must finance its entire invoice book.|
Factoring makes sense if you own a small business and don't have the time or staff to chase down invoice payments. You might find it worth paying a slightly higher fee in return for not being responsible for collection. You might also prefer factoring if you don't mind your customers knowing you are financing their invoices. Finally, you might prefer factoring if you only want to finance certain invoices, say the largest ones or ones for customers that presented collection issues in the past.
On the other hand, you might prefer discounting if your business is large enough to have a finance department that can pursue collections on its own, as the fees for discounting are smaller and you can pocket the savings. You also might prefer discounting if you have many customers and don't want them knowing you are financing your invoices—perhaps it interferes with your relationship with your customers or it disadvantages you when negotiating a good deal with suppliers. For example, you might find it hard to get a good discount from your suppliers if they know you are getting immediate cash flow from your own invoices.
One other option is called "confidential factoring," in which the factor masks the fact that it is collecting the invoices. This makes sense when you don't want to be responsible for collections but want to keep the invoice financing confidential. For instance, if you are a retail wine merchant who invoices purchases above $500 and who makes recommendations, you might fear your customers would perceive a factor as an intrusion upon a trusting merchant-customer relationship.