When your business is in a cash flow squeeze and you can’t get a bank loan, you may want to consider two valuable sources of funding: invoice financingand invoice factoring. Not only can these provide on-demand or ongoing sources of funding, they may also come with credit management services that can help you collect payments from customers
But what exactly is the difference between invoice financing and invoice factoring? In many ways they are very similar, yet they differ on some very important features.
What is invoice financing?
If your business offers extended credit terms to customers (between 30 and 90 days), invoice financing allows you to use your invoices as financial proof that you can pay the lender back on an advance. You can usually get between 75% and 90% of your invoice upfront from the lender and then once your customer pays the invoice, you’ll pay the lender back. This prevents you from having to wait to get your money, which is important if you need working capital.
What is invoice factoring?
Invoice factoring is similar to invoice financing in that you still receive between 75% and 90% of the invoice upfront from the lender. However, in contrast to invoice financing, invoice factoring involves actually selling your invoices to a third-party. Invoice factoring companies will collect the full amount of the invoice from the customer on your behalf.
Does your business have poor credit or no credit at all?
Invoice financing and invoice factoring can be great options for businesses with credit scores that fall short of the high standards required by banks and many other financial institutions. This is because these financing options are usually based more on the strength of your accounts receivables than on your credit history. If your business is still young and doesn’t have much credit built up or is suffering from a poor credit history, then an invoice-based financing solution may be right for you.
More flexibility. You get to pick and choose which invoices to finance and when.
Less flexibility. Invoice amounts are typically advanced in the order received.
Monthly rate (usually 2%-3%) that depends on the amount of your invoices.
High fees (as much as 10%-25% of the invoice amount) for selling a single invoice. Lower fees may be offered for long-term commitments.
Your business usually deals directly with the customer for repayments.
The factoring company will usually have a debt collection service retrieve payments on your behalf.
Private. Customers typically won’t know you are using a financing company.
Less privacy. Customers will be aware you are using a factoring company when contacted about payment from the third-party. However, some companies may offer options for keeping their collection services confidential (i.e. having customers send their payments to a trust account held in your business’s name)
How to compare the pros and cons for your specific business needs
Keep in mind the following differences when deciding between invoice factoring and invoice financing:
Flexibility. Invoice factoring may require you to finance most or all invoices at the maximum funding rate possible. On the other hand, invoice financing lets you choose which particular invoices and even which customers you want to finance.
On-demand vs ongoing funding. As invoice factoring may require you to finance your entire sales, you should think of it as a line of credit linked to your account receivables. This means you have access to an ongoing source of funding. However, invoice financing allows you to select which invoices to finance and when, giving you on-demand funding. Keep in mind that many lenders who offer invoice financing also offer business lines of credit as well.
Debt collection/management services. Invoice financing may or may not offer debt collection services, although businesses using invoice financing are more likely to have credit and debt management departments, meaning they won’t need these services. In contrast, invoice factoring companies almost always come with debt management services.
Confidentiality. Invoice financing may offer confidentiality as far as your customers knowing or not knowing whether you’re using a financing company to collect invoice payments. However, invoice factoring usually means your customers are notified that their invoices are going to be managed and collected by a third party.
Which one is right for my business?
Because of the flexibility and credit management services, invoice financing is popular among smaller businesses. At the same time, invoice factoring is usually better suited to larger companies that have in-house collection services.
However, it ultimately comes down to your particular situation. You can ask yourself the following three questions to help decide what’s best for your business:
What do I need the funds for? If you need an ongoing source of financing because your business is growing quickly, invoice factoring may be the right option for you because you can save by committing to a long-term contract. But if you’re strapped for cash only on occasion, such as when trying to make payroll or when dealing with seasonal down periods, invoice financing may be better-suited to you since you’re able to choose how many invoices to finance and when.
Do I need credit/debt management and collection services? Smaller businesses may want to take advantage of credit management services that invoice factoring companies offer while larger businesses may not need such services.
How much can I afford to pay? One drawback of invoice financing is cost. If you’re occasionally financing single invoices (or single batches of invoices), setup and maintenance costs will be higher. On the other hand, the credit management services that come with invoice factoring are an added expense embedded into the discount rate. Make sure you’re well aware of all costs associated with any type of financing before you select that financing option.
Kyle Morgan is a producer for finder.com who has worked for the USA Today network and Relix magazine, among other publications. He can be found writing about everything from the latest car loan stats to tips on saving money when traveling overseas. He lives in Asbury Park, where he loves exploring new places and sipping on hoppy beer. Oh, and he doesn't discriminate against buffalo wings — grilled or fried are just fine.
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