Invoice Factoring vs Invoice Discounting: what type of invoice financing is right for your business?
By Alan Boswell Group
Invoice factoring and invoice discounting are two types of invoice financing. Choosing the right type of funding for your business could be key to maintaining a healthy cash flow. We take a look at these two different types of invoice finance.
What is invoice financing?
A large number of UK businesses use some form of invoice financing, a form of borrowing which releases cash from a company’s accounts receivables (unpaid invoices). Invoice finance is designed to stabilise cash flow and to minimise the risks associated with trading on credit.
For small and medium-sized enterprises (SMEs), habitual late payments can be crippling. A shortage of cash might leave a company unable to pay staff and other overheads, buy stock, or take advantage of large-order discounts. Unavailability of earned income can tarnish relationships with suppliers and stunt business growth. Businesses that rely on a small number of high-value sales are particularly vulnerable as the risks are much higher when extending credit.
A study carried out by the Chartered Institute of Credit Management (CICM) revealed that, in 2020, 51% of SMEs in the UK were affected by late payments, bearing a collective debt burden of £17.5 billion. The COVID-19 pandemic can’t take all the blame for this startling statistic. In 2019, 54% of SMEs were owed a total of £23 billion. With insolvencies and payment defaults predicted to increase by up to 30% worldwide over the next year, some businesses will not be able to trade out of the difficulties that the pandemic has created.
What is invoice factoring?
Invoice factoring is when you sell your invoices to a finance provider, who take over the role of creditor and assumes responsibility for collecting your customers’ payments. However, if a customer defaults you must return any advance payment made to you by the finance company.
Before you’re accepted for invoice financing, the finance provider will carry out credit checks on you and your customers. Besides credit history, approval and fees will be influenced by several other aspects of your business, including:
annual turnover;
age of the business;
structure of the business (sole trader, limited company, partnership, etc);
number of invoices you wish to finance per month;
total value of your assets as shown on the balance sheet;
payment terms of your invoices;
reason for wanting invoice finance;
the industry you work in (the level of risk for a finance company varies according to the kind of service or goods you provide; for example, the typically contractual nature of trade agreements in the construction industry can provide additional challenges for the funder).
How does invoice factoring work?
Each accounting period (typically a calendar month), the finance provider pays you an agreed percentage of the total value of your invoices. This is usually between 80 – 90%. They’ll conduct credit control on your behalf, and when your customers have made their payments, the finance provider pays you the balance, minus their fee.
There are two main elements to the charges you’ll pay. These are:
service fee
interest on the loan extended to you
The service fee covers administration, credit checks, and services such as management of the invoice ledger, customer communication, and recovery of late payments.
The interest fee is determined by the number of invoices, the value of invoices, and the perceived level of risk.
Typically, the higher the value of the invoice, the lower the discount fee and vice versa.
Invoice financing providers will sometimes offer an optional non-recourse facility, also known as bad debt protection. Non-recourse factoring relieves you of liability for late payments and non-payments. In this agreement, the financing company are not able to claim back the credit they have extended you if a customer defaults on an invoice.
In certain circumstances, you might need to factor a single invoice. This is called spot factoring, and the charges are proportionately high, but it can provide a flexible alternative for those who only require funding against certain invoices, perhaps those of higher value.
Advantages of invoice factoring
Factoring releases equity tied up in unpaid invoices.
Stable cash flow facilitates stock buying and business growth.
A factoring service handles the administration of invoices, including payment reminders and debt recovery, freeing up a small business’s time and resources.
You don’t need any other assets for security, although Personal Guarantees may be required.
Disadvantages of invoice factoring
Responsibility for chasing payments lies with the financing company, although if you are well matched with the right provider, they will ensure this function is conducted in a manner that acts as a continuation for your brand, preserving customer relationships.
Factoring is slightly more expensive than a bank loan but is a different service so the two cannot be compared. However, it is worth remembering that it delivers a higher level of service and flexibility.
Only invoices to business customers are eligible.
What is invoice discounting?
Invoice discounting is a discreet lending service, typically suitable for larger companies who have the resources to manage sales ledgers and debt collection. Because the discounting company doesn’t have direct contact with your clients, the risk for the lender is potentially higher. For this reason, it can be harder for businesses to get approved for this form of funding.
Requirements of a discounting company include:
a turnover that exceeds a set threshold (this will vary depending on the company);
a minimum trading history;
a positive net worth on the balance sheet;
an established method of credit collection;
evidence that your customers pay on time and without dispute.
How does invoice discounting work?
When you raise an invoice, you send a copy to the discounting company, who verifies its validity and lends you approximately 90% of the invoice value. Your customers pay you, and you repay the funder the amount they advanced, plus a fee. Alternatively, your customers can pay into a confidential trust account in your name, handled by the discounting company, who pays you the balance minus their fee. If a trust account is used, your customers won’t know that it’s being handled by a third party.
The role of an invoice discounting company does not extend beyond providing funding. You are always liable for debts and fully responsible for your business’s credit control.
Advantages of invoice discounting
Discounting releases equity tied up in unpaid invoices.
Stable cash flow facilitates stock buying and business growth.
When you use a confidential invoice discounting service, your customers are unaware of your funding facility.
Your relationship with customers is uninterrupted by a third party.
Invoice discounting is cheaper than factoring.
Disadvantages of invoice discounting
Only invoices to business customers are eligible for discounting.
Not every business will be suitable for invoice discounting.
Client Handles Own Credit Control (CHOCC)
CHOCC is blend of invoice factoring and invoice discounting. Your customers will pay the finance provider directly, but it’s your responsibility to issue invoices and chase payment. Your customers will be aware that you’re using a CHOCC service, but you’ll be dealing with them directly.
The right form of invoice financing for your business
Invoice financing is just one form of business funding that can protect your business and help to maintain a healthy cash flow needed for growth and sustainability. Invoice discounting or invoice factoring may be suitable for your business if you are looking to free up cash in the short term whilst you wait for customers to pay your invoices. There are also other business finance options available, such as cash flow finance, so it’s important to speak to a commercial finance broker, such as our partner Hilton-Baird Financial Solutions, who can recommend the most suitable funding for your business’ goals.
To discuss how Invoice Factoring, Invoice Discounting or Credit Insurance could help your business, contact Alan Boswell Group on 01223 324233.