Cash flow problems are the bane of many small businesses. You have good customers who pay their bills within terms. But, your industry terms are 60 to 90 days. That is a long time to wait for a payment to come in. You have to pay supplier invoices, payroll, and utility bills in the meantime. You need the cash tied up in those invoices.
Two of the most popular options for freeing up some needed cash are invoice discounting and invoice factoring. Both leverage the value of your open invoices to give you the cash you need. The way they work, however, is a bit different.
To understand the differences between the invoice discounting and invoice factoring, you need to understand the similarities they share first.
Both are offered by third party providers. These external companies provide cash advances as a percentage of the value of the invoices you have currently open. The percentage is usually between 70 and 90 percent of the invoices' value. Once your customers make payment, you receive the remainder, minus the cost of discounting or factoring.
The Biggest Difference
The biggest difference between the two comes down to one thing: who handles the invoice processing, payments and collections?
With invoice discounting, you (the client) retain control over the sales ledger. You are responsible for all invoice and payment processing. You are also responsible for collection efforts on past due invoices. This kind of arrangement is transparent to your customers, since all payments still go to you.
With invoice factoring, the factor takes over those functions. Once you send out the initial invoice, the work goes to the factoring company. They receive payments and they handle collections. This arrangement is very evident to your customer since they will send payments to the factoring company.
Who Uses Invoice Discounting?
Companies that use invoice discounting tend to be larger than those who use factoring. Most discounting providers require their clients to have at least $500,000 in annual revenue, while some require a minimum of $1,000,000. This makes discounting unavailable to many small businesses.
Since the invoice discounting provider does not take control over the payments and collections, there are often stricter requirements for qualification. A typical client will need to have a well-established credit rating and solid credit control procedures in place before the discounter approves an application.
Who Uses Invoice Factoring?
Small businesses are the most likely users of invoice factoring. Many will have annual revenue flows of $200,000, though some factoring companies will consider start-ups with flows as low as $50,000. This makes it a good option for small companies trying to grow and start-ups with an established customer base.
Because the factoring company takes over the payments and collections for the client, there are less stringent requirements for approval. They will check the creditworthiness of the applicant's customers and do a background check on the business' owners and managers. But, the problems that would normally derail a discounting arrangement or a typical business loan are often not a big deal in a factoring arrangement.
Which Solution is Right for Your Business?
If you are considering whether discounting or factoring is the best choice for your business, you should consider both options carefully. You need to select the one that is best for your company, your clients, and your future.
Both options offer similar benefits:
- They free up cash in outstanding invoices.
- Once they approve your application, they can get you the cash you need within a couple of business days.
- They can help you improve your cash flows to pay bills, make payroll, or get needed supplies for a big order.
- They can help you pay supplier invoices promptly to improve your company credit rating.
- You can get competitive pricing.
For small businesses, factoring offers other benefits you should consider:
- It gives you professional payment processing and collections, without the need to hire extra employees.
- It frees up your time to focus on expanding and building your business.
- It gives you credit screening before you take on new clients. This helps improve the creditworthiness of your customer base.
Knowing the differences between invoice discounting and factoring will help you find the right solution for your company. Just be sure to have an accountant or lawyer read over any agreement from a discounter or factor before you sign. It will give you the reassurance you are making the right choice.