Anyone who runs a business understands the challenges that cash flow can create. When business owners are unable to qualify for loans, they often turn to invoice financing or factoring to improve cash flow. Both options allow businesses to collect on unpaid invoices instead of having to wait around for delinquent clients to pay.
However, even though financing and factoring are similar processes, closely comparing invoice financing vs factoring will reveal key differences. When deciding between the two, these differences can help you understand how each of the two processes will impact your relationship with your customers as well as your own financial stability.
What Is Invoice Financing?
Invoice financing is when you use unpaid customer invoices as collateral that allows you to borrow from a lender, essentially allowing you to get paid in advance for the invoices by selling your customer’s unpaid invoices to a third-party company. Once you collect full payment of the invoice, that money is then passed on to the lender to pay off the loan.
Like other small business loans, invoice financing involves paying interest on the amount of money being advanced, which is generally between 3% and 5% that is then charged monthly. It also tends to require careful monitoring of the paperwork involved since you are taking responsibility for a loan and must ensure you pay it back within the allotted time period.
The factor is then responsible for collecting the invoices. This is one of the primary distinctions between invoice financing vs factoring. With factoring, the third-party interacts with your customers directly to collect your invoices.
Of course, factoring companies get something out of the deal, that being a percentage of the invoice you are waiting to be paid for. Depending on the company you hire, you might only receive 85% of the total value of your invoices, but in turn, you don’t have to deal with the collections process.
Example of Invoice Financing
An owner operator signs a contract with an invoice financing company to pay 4% of any invoices submitted each month, no minimums required. During the first month, the owner operator submits an unpaid invoice of $3,000 and receives the full amount from the lender.
Though the customer is expected to pay it by the end of the following month, the business needs the cash to maintain a positive bank balance in the meantime. At the end of the month, the owner operator pays a $120 fee owed for the advance.
When the customer pays the full amount the following month, the owner operator pays it directly to the financing company to pay off the account balance. If they don’t do this, the same fee will be applied at the end of the next month.
Since a percentage is lost, the owner operator only uses the service on an as-needed basis. During months when cash flow is steady, the owner operator doesn’t submit any invoices because they have no need for advances on what they are owed.
Unlike invoice factoring, financing allows your business to keep customer information secure, among other benefits, which include the following:
- Immediate access to funds
- More flexibility with when to finance individual invoices
- Choose which invoices to finance
- Customer information kept secure
When comparing invoice financing vs invoice factoring, financing can present certain drawbacks, like these:
- Set time period to pay off loaned amount
- Interest charged monthly, as with other loans
- Business owner still required to collect on invoices
Example of Invoice Factoring
A small trucking company issues invoices that are payable within 60 days. However, unexpected engine repair costs mean that the business needs an immediate influx of cash to continue providing services.
In order to access the money immediately, the trucking company sells their current batch of unpaid invoices to a factoring company, and those invoices are worth $14,000. The factoring company pays 90% of the value of the invoices, so the trucking company receives $12,600 to make immediate repairs.
As part of this arrangement, the trucking company gives their customer’s information to the factoring company, which contacts the customers and collects the full value of the unpaid invoices. In future months, the trucking company makes an arrangement with the factoring company to pay a lower percentage for processing all invoices.
Factoring gives business owners the opportunity to get cash in their hands from invoices that have yet to be paid. In certain industries, this service is essential to run a profitable company. Benefits include immediate payment and not having to be responsible for collecting unpaid or delinquent invoices.
When considering invoice financing vs factoring, there are certain disadvantages to factoring over financing. These disadvantages include the following:
- High fees up to 15% of the total of the invoices
- Customer information shared with third-party factoring company
- Payment grouping, meaning less flexibility to select specific invoices
Comparing Invoice Financing and Invoice Factoring
Both invoice financing and invoice factoring allow businesses to get paid for invoices without delays. The main difference is in the type of financial relationship. While invoice financing creates a lender-to-business relationship, invoice factoring creates a lender-to-customer relationship.
Factoring is more like a line of business credit with consistent, ongoing access to payments, whereas financing offers the flexibility of selecting specific invoices for advance funding. When comparing invoice financing vs factoring, keep in mind that financing companies don’t offer the debt collection services provided by factoring companies.
However, using a third party to collect requires alerting customers that their information might be shared. Depending on your business-related needs, it’s important to choose the invoice option that makes more sense for your situation.
As with other loans, invoice financing generally involves making monthly interest payments on the amounts loaned. They also come with loan term limits. If the borrowed amount is not paid back within that time, penalties will be applied. Invoice factoring is associated with higher fees since the factoring company also takes on the responsibility of managing collections.
Initial Invoice Advance
When comparing invoice financing vs invoice factoring, keep in mind that both processes provide a similar service, namely advancing the amounts of unpaid invoices immediately. However, the handling of these funds varies based on whether the advance is made as a loan borrowed against the promise of a future payment or as a purchase of the invoice itself.
When a lender works directly with the customer, the invoice advance is known as invoice factoring. When they work on a business-to-business basis, the process is called invoice financing.
Invoice financing tends to incorporate much more flexibility. With factoring, invoices are generally submitted as they are received or they are paid in bulk on a monthly basis. However, the loan format of invoice financing means that the amount must be paid back within a certain amount of time.
Invoice & Payment Handling
Since the business owner is responsible for collecting invoice payments to pay back the lender, invoice financing is generally better for occasional use. Invoice factoring can be easily set up in a way that allows for bulk monthly payments on large quantities of invoices. Despite the higher fees associated with this option, it does allow the business owner to relinquish all responsibility for collections with minimal hassle, which can be worth it.
Since factoring companies perform collections or contract out to collection agencies, this approach requires that customer financial and contact information is shared with another business. As such, you’ll need to communicate this fact with your customers and receive confirmation from customers who acknowledge that they understand their confidential information will likely be shared with a third party. If confidentiality is a concern, invoice financing may be a better option for your business as well as your customers.
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Factoring an invoice means selling that invoice to a third-party factoring company for a certain fee or percentage. The company will then contact the invoice recipient to obtain the payment.
It depends on your business and your company’s financial situation. Factoring can be a reliable way to improve cash flow, though invoice financing may be better when you need a short-term advance.
Yes, invoice financing involves using invoices as collateral against the amount being borrowed.