Securing an effective and reliable source of finance is vital for any business. It opens the door to future growth opportunities, can ensure businesses remain well-stocked, and can be used to raise capital quickly to plug financial gaps during emergencies. For small businesses, however, the right method of finance can be the deciding factor between success and failure.
To that end, invoice financing and invoice factoring are often used tools. It is excellent for businesses with a tight cash flow, having their capital stuck in unpaid invoices for most of the month. While many businesses have to wait some time before receiving payment, this can become a real problem when dealing with serial late-payers, especially if they are your most valuable invoices. Invoice financing and invoice factoring can help deal with this problem.
Both of these tools have their uses, being better suited to some scenarios than others. However, many conflate invoice financing and invoice factoring, given the similarity between the two. Naturally, this can cause issues if the tools are misused. In this article, we will cover the key differences between invoice financing and invoice factoring, ensuring you can use the right method for your business.
What is invoice financing?
Invoice financing, often referred to as accounts receivable financing, is essentially the practice of leveraging your unpaid invoices to raise capital. This is done by using your unpaid invoices as security, borrowing the value of these invoices from a lender. You can usually expect to receive between 80%-90% of your invoice’s value using this method, typically in a lump sum.
You will be expected to repay your loan once your clients pay the invoices you took out the loan against. Invoice collection must still be conducted by your business, however. Some lenders may offer to connect to your accounts, deducting money from your clients’ invoice payments automatically, then forwarding you any remnants. Otherwise, you will be expected to repay the loan, plus fees and interest, once your client pays their invoice.
Also Read: A Guide To Using Invoice Financing For Small Business
What is invoice factoring?
Invoice factoring, often referred to as accounts receivable factoring, is another form of finance that relies on leveraging unpaid invoices to raise capital. It is similar to invoice financing, though it has some noteworthy differences, as we will discuss.
Unlike invoice financing, using invoice factoring essentially sells your unpaid invoices to a factoring company. This “sale” will raise a similar amount, usually within the range of 80%-90% of an invoice’s value, which will be paid out in a lump sum. The factoring company will then assume responsibility for collecting the invoice or invoices. This is the most significant difference between the two methods, one that can have a considerable impact.
Once the factoring company has collected the invoice or invoices, it will deduct the value of the loan, plus fees and interest. Afterwards, the company will send you any money left over, if any. This means that your clients will be paying the factoring directly, making them aware that you have involved a third party. This could lead to the perception that your business is in financial trouble, having to rely on outside sources of finance to prop itself up.
Key differences between invoice financing and invoice factoring
Although similar, invoice financing and invoice factoring have a few vital differences. These differences could be enough to make one the perfect fit for your business, and the other not the ideal solution. Here are the key differences:
- Invoice collection – As we mentioned, invoice financing is simply the practice of taking a loan out against an invoice. This means that your business will retain responsibility for collecting these invoices. However, invoice factoring essentially sells your invoices to a factoring company, transferring responsibility for collection onto them.
- Funding process – Invoice financing uses your outstanding invoices as backing for a loan. Your lender will then open up a line of credit for you, under the assumption that your client will pay their invoice later on. Once they do, you will repay the loan plus fees and interest. Invoice factoring, however, is a bit different. This method is transactional, with your business’s unpaid invoices being bought for a lump sum by a factoring company. This purchase is made at a discount, and does not usually result in the company forwarding you the full value of the invoice upfront. Instead, the company will send a portion, collect the invoice payment, make the necessary deductions, then release the rest.
Advantages to using invoice financing and invoice factoring
Despite their differences, both methods provide businesses with similar advantages. These are:
- Flexibility – This is a huge perk for any business looking for finance, regardless of what their reason is. As invoice financing and factoring both use invoices to back the loan, the value of these invoices and your clients are the main points of interest. This means that you can expect to obtain these forms of finance even if your credit history isn’t great.
- Quick access to finance – Whereas other forms of finance require you to wait extended periods of time to receive funds, invoice finance and factoring is fast. The application process is fairly straightforward, with the emphasis being placed on your unpaid invoices and clients. Once approved, you can expect to receive the funds in a short space of time. This has the added benefit of freeing money from your cash flow immediately, rather than at the end of the month.
Disadvantages of invoice financing and invoice factoring
Naturally, both forms of finance have their disadvantages. They are fairly similar between the two, though some differences exist. These disadvantages are:
- Reliant on your clients – This can be a double-edged sword. While it can be helpful for businesses with a poor credit history, unreliable clients can scupper an attempt at obtaining finance. Too high a risk may result in your application being rejected, or your business being asked to pay back the loan if your client doesn’t pay. Late payments from your clients may also result in additional fees, which can make both methods fairly expensive.
- Reputational harm – This is mostly only true for invoice factoring. As your clients will know you have contracted a third party, they may develop a negative perception of your business. Your clients might think that your business is in financial trouble, or possibly is poor at handling money. Alternatively, clients might be displeased with how the factoring company goes about invoice collection. As they do so on behalf of your business, this could also reflect poorly on you.
Conclusion
Both invoice financing and invoice factoring are excellent methods for raising capital. They are especially useful for businesses with much-needed capital stuck in their cash flow, in the form of unpaid invoices. Both methods can help free this capital, making it available immediately for growth purposes or urgent use. However, though the methods are very similar, they are not the same. As such, you should take care to know the differences between the two, and how they fit your business’s situation.