Invoice finance is vital for SMEs suffering the ramifications of late customer payments. With two-thirds of small businesses facing this issue regularly, it’s no surprise many are left exploring external funding options to minimise the burden on cash flow.
Invoice finance typically comes in two forms: discounting and factoring. Both are used to improve cash flow and overcome the issue of delayed payment. However, you should be aware of the nuances in how they work and the potential implications on your business.
We explore the differences and similarities between invoice discounting and factoring – and which is best for your needs.
- Invoice discounting and factoring similarities
- Five differences between invoice discounting and factoring
- Who benefits from discounting?
- Who benefits from factoring?
- Find an invoice finance facility that suits your business
Invoice discounting and factoring similarities
Although they are two distinct types of invoice finance, discounting and factoring share many similarities.
Both offer significant cash flow, using your unpaid invoices as collateral to unlock capital. All you need is unpaid invoices issued to other businesses to access funding, rather than lengthy documentation or assets, making it accessible to many firms.
It can quickly release cash for your business in as little as 24 hours. It is therefore a helpful solution for those seeking urgent funding to fill financial gaps.
Both discounting and factoring facilities will grow as your business does. The more invoices you send, the more funding you can leverage. This means there is a reduced risk when bringing in new customers, even if they are late in paying. However, the funding rates and other terms will vary between lenders, so it is essential to understand the specific conditions of your arrangement.
Finally, any invoice finance you receive – discounting or factoring – must be repaid. Typically the money is borrowed for a 90 day period, but it can be more or less. It’s crucial to secure payment from your customers, which will be used to clear the balance, within this timescale. The consequences of not receiving the payment within the agreed timeframe can be to reduce the level of funding available to the business, so good credit control is still of paramount importance.
Five differences between invoice discounting and factoring
Although there are many similarities between discounting and factoring, numerous crucial differences exist. The right solution for each business will be determined by their preferences, eligibility and other requirements.
We have listed the five most prominent differences between discounting and factoring.
Payment path
One of the most significant contrasts between an invoice factoring and a discounting facility is who receives payment.
In a discounting scenario, invoices will continue to be paid to you directly as they would have previously, but now into a trust account held by the lender. Your invoices will need to be updated with new payment details associated with this account.
For factoring, payment will be made direct to the lender. Your invoices will also need to be updated with new payment details associated with an account set up by your lender.
Confidentiality
An invoice discounting arrangement is usually confidential, meaning your customers won’t be aware you are working with a third-party lender. As payment goes directly to the lender in a factoring facility, you must inform customers.
Undisclosed invoice discounting is your best bet if you seek privacy when using external finance.
It isn’t always cut and dry, however. Even for discounting facilities, some lenders may insist the customer pays them directly to reduce risk, especially if you do not have a substantial turnover. This means you will need to alert your customers. It is known as disclosed discounting.
It is worth checking the market for options to see if you would need to disclose your invoice finance facility or not.
Credit control responsibility
As payment goes directly to the lender, most factoring arrangements will give them the responsibility of seeking compensation from your customers. With chasing payment taking up a great deal of time and effort for SMEs, many companies will be attracted to the prospect of the lender taking responsibility for this.
In a discounting agreement, you will need to continue to chase payment yourself. Securing this payment is key to paying off your invoice funding, or you otherwise risk having lower availability in your facility.
Factoring is also more likely to have a non-recourse clause, which means the lender agrees to take on the risk of a customer not paying, and you won’t be required to cover the difference. In discounting (including disclosed arrangements), you will be liable if your customers don’t make their owed payments.
Again, the exact details will differ between facilities, so it is crucial to speak to the lender to understand the terms available for your business.
Customer contact
The nature of a discounting arrangement, in which you do not need to disclose to customers that you’re using external finance, means you retain control of your sales ledger and customer relationships.
Many businesses will prefer this scenario, as they remain the point of contact for their customers, preventing any inconsistent experiences or potential damage to relationships.
With a factoring facility, you give control to the lender, who may contact customers on your behalf (such as to chase payment).
Fees
Another crucial consideration when comparing factoring and discounting facilities is the cost involved.
Generally, invoice finance is a cost-effective form of funding. However, fees are involved.
A factoring arrangement will typically have higher costs due to the lender’s increased role in the payment process. Service fees are between 0.75% and 2.5% of annual turnover.
If your arrangement includes a non-recourse understanding, you may also experience higher interest to offset the lender’s risk and credit protection charges.
Fees will vary between lenders, so check the terms and conditions for your loan carefully.
Who benefits from discounting?
Invoice discounting is commonly used by companies that want to absorb any perceived increased risk and maintain confidentiality with turnovers over £1,000,000.
It will be more accessible to businesses with higher turnovers as this offsets the risk to the lender awaiting repayment.
It’s also ideal for those looking for a more hands-off option, where they maintain control of their credit control practices and customer relationships.
It is worth noting some lenders will only provide disclosed discounting if your turnover is lower, so it should not be taken for granted that it will be a confidential facility.
Who benefits from factoring?
Factoring is generally used by smaller companies who perhaps have less of a credit control function or a poorer credit rating, for example. As the lender has more control and is paid directly by the customer, they will be willing to accept SMEs with a smaller turnover, making it accessible to many businesses.
Factoring is also an excellent solution for those wishing to reduce the time and effort spent chasing invoices, instead passing this onto the lender.
Find an invoice finance facility that suits your business
Whether discounting or factoring is best depends largely on your circumstances and preferences. However, understanding the key features of each will prove critical to making the right choice for your business.
It is also vital to understand what options are available to your company based on your unique eligibility criteria.
If you are considering invoice finance, factoring or discounting, for your business, Pegasus will pinpoint the perfect solution for your needs. We have over 60 different invoice finance lenders in our network, enabling us to connect you with the right people and negotiate competitive terms.