The Difference Between Invoice Discounting vs. Factoring

Invoice discounting and factoring are two forms of invoice financing. Invoice financing is a type of business funding that allows businesses to borrow money against their accounts receivable. It’s an extremely short-term form of borrowing. And the loan amount changes when the value of the outstanding invoices changes.

Small companies like startups and new businesses aren’t always able to secure traditional loans from banks. So, they turn to online lenders for alternative financing. It’s also a bonus that online lenders approve funding much quicker than traditional banks.

Invoice financing is used by businesses that sell goods and services to a large number of customers on credit. However, this type of financing is typically only available to businesses that serve other companies. Since payment relies on the customer’s ability to pay, factoring companies find it less risky to deal with businesses.

Keep reading to find out how invoice financing works. We’ll also help you understand the difference between invoice discounting and invoice factoring.

What Is Invoice Discounting?

Invoice discounting is a short-term loan using your outstanding invoices as collateral. An invoice financing company agrees to lend you a portion of the total value of the invoices upfront in the form of a loan or line of credit. How invoice discounting works is you receive a cash advance of 80% to 90% of the total invoice amount.

When the invoice comes due, you collect from your customers, and you pay back what you borrowed plus fees and interest. Invoice discounting fees are usually between 1% and 3% of the invoice total. Your agreement will tell you how often you’ll be charged with fees, either weekly or monthly.

It’s important to note that with invoice discounting, you’re still in charge of your sales ledger and processing the invoices. You’re also responsible for collecting your accounts receivable.

When Is Invoice Discounting Typically Used?

Invoice discounting is best suited for businesses that need immediate access to cash to cover working capital expenses. Typically, invoice financing is both easy to qualify for and secure. Since the loan is secured by the outstanding invoices, it means companies don’t need to provide collateral to borrow money.

Invoice discounting offers a flexible finance solution for businesses to cover cash flow gaps. This is why companies in the construction, manufacturing and wholesale industries use this type of financing. Some ways businesses use invoice discounting funds include:

  • Rent and other daily operating expenses
  • Buying inventory or raw materials
  • Repairing or replacing equipment
  • Payroll or hiring additional employees
  • Advertising and marketing expenses

What Is Invoice Factoring?

Invoice factoring is a type of credit where a business sells its outstanding invoices to a lender. This is the main difference between the two forms of receivable financing: Invoice discounting is a loan while factoring is a sale.

There are two types of invoice factoring: recourse and nonrecourse. With a recourse contract, any unpaid invoice is your responsibility. You’re obligated to buy them back or replace them with a current receivable. But in a nonrecourse factor, the risk is on the lender if a customer doesn’t pay.

Similar to invoice discounting, the business will receive a percentage of the outstanding value of its invoices in advance. Invoice factoring companies typically pay up to 100% of the total invoice value.

The factoring cost is usually between 0.5% and 5% of the invoice total. Lenders base your factoring rate on your sales volume, your customers’ creditworthiness, the invoice amount, and how long it takes your customers to pay.

But with invoice factoring, the lender takes over the credit collection. Your customers pay them directly, and the factoring company deals with late payments if necessary. Of course, any remaining amount minus fees is paid to you once the invoice clears.

Another way to differentiate between these two types of invoice financing is to ask the question: “Who’s responsible for collecting payments?”

When Is Invoice Factoring Typically Used?

Aside from loans, the only other way for small businesses to raise capital is through equity financing. But many business owners like to retain full control of their companies. So, invoice factoring is a flexible financing option for businesses that aren’t eligible for traditional loans.

It also offers a way for small business owners with less-than-stellar credit to get funding since approval is based on the credit rating of the customers. And there are no personal credit requirements for the borrower.

Some of the ways businesses use invoice factoring funds include:

  • Paying rent and other day-to-day operating expenses
  • Buying inventory or raw materials
  • Repairing and maintaining machinery
  • Buying new equipment
  • Paying wages and salaries of employees
  • Paying tax liabilities

Invoice Discounting vs. Invoice Factoring: Key Differences

Every loan agreement is different because each lender has its own requirements, payment terms, and fee structure. This is true for invoice financing contracts, as well. Here are the key differences between invoice discounting and invoice factoring.

  • Invoice discounting is treated as a short-term business loan, and invoice factoring is essentially a sale of unpaid invoices.

  • With invoice discounting, the business retains the responsibility of collecting payments from its customers. In contrast, under factoring, the factoring company takes on the responsibility for debt collection and deals with customers directly.

  • Invoice discounting providers only consider your credit qualifications to approve the loan, while factoring companies require credit checks on your customers before agreeing to buy your invoices.

  • The structure of invoice discounting doesn’t alert customers that you’ve financed your invoices. You are in charge of the invoices. This allows you to protect customer relationships because you are still their point of contact. But it may also mean spending time and money to collect payments.

  • With invoice factoring, you don’t have to worry about chasing late payments. However, your customers may know that you’re using your accounts receivable as collateral to borrow money. This could lead to a negative perception of your business, especially if the factoring company employs harsh collection methods. However, this is only a small worry. Factoring providers want your continued business, so they’ll be as discreet as possible and present themselves as a part of your company.

  • Since invoice discounting is a loan, you are still obligated to pay it even if your customers don’t pay in time or at all. On the other hand, in a nonrecourse factoring agreement, you don’t have to pay the lender if they can’t collect from your customers.

  • Factoring is typically more expensive than invoice discounting because lenders have to account for the additional expense of the collection process and the risk of bad debts in a nonrecourse contract.

See How Clarify Capital Can Help You With Invoice Factoring

Businesses large and small go through periods of struggling to have a steady cash flow. This is why access to business financing is critical to running and growing a company.

At Clarify Capital, we work with more than 75 lenders, so you have financing options and you get the best rate. Our mission is to help business owners like you achieve your business goals by getting the funding you need. We also know you’re busy, so we make the process quick and easy.

When you finance with us, you have a dedicated Clarify advisor to help you choose the best financing options based on your business needs. Your advisor will work with you throughout the process and help you understand the terms of your invoice financing contract.

Fill out our online application today. It takes as little as two minutes! Or contact us to speak to a Clarify advisor directly.

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