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Invoice Financing

Terms like “Invoice Finance,” “Invoice Factoring,” “Debt Factoring,” and “Invoice Discounting” are often used interchangeably and sometimes mistakenly. Grasping the nuances among these financial solutions is crucial for businesses looking to manage their cash flow effectively and make informed financial decisions. 

At the heart of the matter is Invoice Financing, an umbrella term encompassing short-term financing solutions businesses use to access funds based on the value of their outstanding invoices, including invoice factoring and invoice discounting. 

What is invoice factoring?

Invoice factoring also known as debt factoring is a type of short-term financing where a business sells its accounts receivable (invoices) to a third-party factoring company at a discount. This arrangement provides merchants with immediate cash flow, which can be crucial for covering operational expenses, investing in growth, or managing cash flow gaps. 

Here’s how it works:

  1. A merchant issues an invoice to a customer for goods or services rendered.
  2. Instead of waiting for the customer to pay, the merchant sells that invoice to a factor at a discount, typically between 70% and 90% of the invoice value.
  3. The factor pays the merchant upfront for the invoice amount minus their fee.
  4. The factor then takes on the responsibility of collecting the full payment from the customer.

Advantages & disadvantages of invoice factoring

Merchants should weigh the various pros and cons of invoice factoring carefully to determine if it aligns with their needs:

Invoice factoring advantages

  • Immediate cash flow: Factoring provides businesses with immediate access to cash, which is particularly beneficial for covering operational costs, investing in growth opportunities, or managing cash flow gaps without waiting for customers to pay their invoices.
  • Credit management and collection services: Factoring companies typically handle the collection process, which can reduce the administrative burden on businesses and allow them to focus on core activities. This can be especially helpful for small businesses with limited resources for managing accounts receivable.
  • Non-recourse: Merchants aren’t obligated to pay the factoring company if a customer doesn’t pay, as the factor assumes the risk of non-payment. However, there is also recourse factoring, where a merchant must buy back unpaid invoices from the factoring company.
  • No collateral required: Unlike traditional loans, invoice factoring doesn’t require real estate or other significant assets as collateral, as the invoices act as the security for the cash advance.

Invoice factoring disadvantages

  • Costs: Factoring can be more expensive than traditional financing options due to the fees charged by factoring companies. These fees are based on a percentage of the invoice value and can add up over time.
  • Customer interaction: Since the factoring company collects directly from customers, there is potential for impact on customer relationships. Customers may perceive a business’s financial stability differently if they know a third party is involved in invoice collections.
  • Selective factoring might not be possible: Some factoring companies require businesses to factor in all their invoices, not just select ones, which could increase costs if the business has to factor in invoices from customers who typically pay promptly.
  • Customer creditworthiness: Factoring companies evaluate the creditworthiness of a business’s customers, and invoices from customers deemed to be a higher credit risk may not be eligible for factoring, limiting the financing available to the company.

What is invoice discounting?

In simple terms, invoice discounting is a loan secured against a merchant’s outstanding invoices. Here’s how it works:

Suppose a merchant specializing in electrical products sells goods to their customers on net terms. This arrangement allows customers to receive goods immediately while delaying payment for 30, 60, or even 90 days. Such a delay can significantly impact the merchant’s cash flow as they continue to incur expenses like rent, payroll, and material costs, all while a substantial portion of their capital is tied up in outstanding invoices.

This is where the concept of invoice discounting becomes relevant. It functions as a cash advance against these unpaid invoices. In this process, the merchant borrows money against their sales ledger from a discounting company, providing the merchant with a substantial percentage of the invoice’s value upfront—commonly around 70-90%. 

The immediate infusion of cash aids the merchant in maintaining smooth business operations. However, this service is not without cost. The discounting company charges a fee, usually 1-3% of the invoice’s total value, to compensate for their services, the interest on the advance, and the risk associated with the possibility that the customer may default on payment.

Here’s how it works:

  1. The invoice discounter gives the merchant a portion of the invoice value (70-90%) upfront.
  2. The discounter keeps a percentage (10-30%) to protect against risks like non-payment.
  3. The merchant continues collecting customer payments. Each time a payment is received, the merchant updates its sales ledger. 
  4. The merchant repays the discounter using the collected funds, covering the initial advance and any agreed fees.
  5. The merchant settles fees with the discounter, including the borrowing cost, based on the time from advance to repayment.
  6. After repaying the advance and settling fees, the discounter releases the reserve amount to the merchant, completing the process.

If a merchant cannot collect payment from a buyer after engaging in an invoice discounting agreement, it can lead to challenges and consequences for the merchant and the invoice discounter. The specific actions and outcomes may depend on the terms outlined in the invoice discounting agreement. 

If the agreement is a recourse arrangement, the merchant is typically responsible for repurchasing the unpaid invoice from the invoice discounter. In this case, the merchant would need to reimburse the discounter for the advanced amount, fees, and any additional costs associated with the transaction. On the other hand, in a non-recourse discounting agreement, the invoice discounter usually assumes the risk of non-payment. If the buyer fails to pay, the merchant may not be required to repurchase the invoice, and the invoice discounter generally absorbs the loss. 

If the invoice discounter holds a reserve amount, the discounter will likely use it to cover part of the outstanding amount. However, the reserve amount is typically a portion of the invoice value and may not fully cover the loss.

Invoice factoring vs discounting – What’s the difference?

Both invoice discounting and factoring help merchants access cash tied up in unpaid invoices but they work in slightly different ways. Here are the key differences:

Invoice Factoring

Invoice Discounting

Ownership

Merchants sell the invoice outright to the factoring company. The factor becomes the owner of the unpaid invoices and handles all collection efforts.

Merchants retain ownership of the invoice. They simply borrow a portion of its value from the discounter. Merchants are still responsible for collecting payment from their customers.

Transparency

Customers are typically informed that merchants have factored their invoice.

Customers remain unaware of the discounting arrangement.

Collections

The factoring company takes over credit control and collects the payment directly from customers.

Merchants are still responsible for chasing overdue customer payments.

Cost

Fees are typically higher due to the added service of credit control and risk assumption.

Fees are generally lower as merchants retain ownership and manage collections.

Suitability

More common for smaller merchants or those with less predictable customer payments.

Often preferred by larger merchants with established customer relationships and reliable payment cycles.

Which one’s right for your business? 

Invoice financing instruments, such as factoring and discounting, offer tailored solutions for merchants eager to optimize their cash flow and fuel expansion. With its immediate liquidity and outsourced credit management, invoice factoring presents a compelling option for businesses seeking to alleviate the administrative burdens of accounts receivable. Conversely, invoice discounting offers a more discreet form of cash advancement, allowing merchants to retain control over their customer interactions and collections. By understanding the distinct features and implications of each, merchants can make informed decisions that align with their operational needs and financial strategies.

Mondu provides embedded factoring solutions through accounting and invoicing platforms, as well as direct solutions to merchants with its variety of Buy Now, Pay Later products. 

Contact us for a free consultation.

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