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Australian SMEs have always found it challenging to qualify for funding from traditional lenders. This lack of access to finance is even more apparent as late payment times have accelerated nationally. In 2021, businesses may need to wait up to 22.9 days to receive payment. Xero report
Invoice finance is a way for businesses to unlock the capital tied up in their outstanding invoices. You can get paid immediately, rather than waiting for 30+ days for your customers to pay. (Note: Invoice Finance is also known as Debtor Finance or Receivables finance).
There are two main types of invoice finance: factoring and discounting. While both of these solutions allow you to turn your outstanding invoices into an immediate cash flow boost, there are some key differences.
What is Invoice Factoring?
Invoice factoring is a funding solution where you effectively sell your accounts receivable to a finance company. The terms of a factoring agreement can vary, but you can expect to receive up to 95% of the value of your unpaid invoice upfront as a cash advance. Note Invoice Finance is also referred to as Debtor Finance and Receivables finance.
Once you have submitted the invoice for factoring, the finance company takes on the responsibility of collecting payment from your customer. When your customer pays the invoice, you receive the remaining balance of the invoice less fees.
Because the finance company collects the invoice payment, your customer will usually be aware of the factoring agreement.
What is Invoice Discounting?
Invoice discounting works similarly to factoring. Once you submit an invoice to the finance company, they will provide up to 85% of the invoice value upfront as a cash advance. When your customer pays the invoice, you receive the remaining balance less fees.
There are some key differences to factoring, including the responsibility for collecting payment from your customer. With invoice discounting, you retain the responsibility for collecting payment of the invoice.
This usually means your relationship with the finance company is confidential, and your customers will be unaware that you have used the invoice to access funding.
For a more detailed look at how these two financing solutions work, read this guide.
The Differences Between Discounting and Factoring
Both types of invoice finance allow you to turn your accounts receivable into a source of readily available funding. But there are several differences between these solutions.
Confidentiality
With invoice factoring, you are selling your accounts receivable to the finance company. You don’t need to spend time chasing payments, but the invoice finance company will deal directly with your customers.
With a discounting arrangement, you essentially use your unpaid sales invoices as collateral to secure a line of credit. The funding relationship is confidential.
The Amount You Receive Upfront
You can expect to receive up to 85% of the invoice value upfront when you factor an invoice.
While this is only the upfront payment and you will receive the remaining balance less fees once your customer settles the invoice, it's something to keep in mind if you urgently need to raise capital.
Cost
Generally, factoring is more expensive than discounting. This is because of the additional accounts management and collections services that are associated with factoring. You are outsourcing these tasks to a finance company.
Option of Non-Recourse Factoring
It’s possible to secure non-recourse factoring when you enter into an invoice finance agreement. This form of factoring transfers the liability for the debt to the finance company. If your customer doesn’t pay the outstanding invoice, you won’t be required to pay back the sum owed.
Non-recourse factoring is much harder to qualify for and more expensive than recourse factoring. However, there is no option for non-recourse invoice discounting.
Accessibility
Invoice factoring is much more accessible to small businesses and those that lack dedicated accounts and collections departments.
To qualify for invoice discounting, you will typically need to demonstrate a history of collecting invoices on time and have a dedicated internal accounts and collections department.
Invoice Factoring vs Discounting
Both types of invoice finance can help you to improve cash flow and better manage your working capital. You can speed up cash cycles and reinvest in your business faster than if you have to wait for customers to pay.
But factoring and discounting are different solutions, each with pros and cons you should be aware of before deciding which is right for your business.
The Pros and Cons of Factoring
Pro - Time Management
With the finance company handling credit control and chasing payments, you are free to spend your time on more dollar-productive tasks. Australian businesses spend as much as 8 hours per week chasing payments, totalling 52 working days per year.
Pro - Credit Checks
If you choose an end-to-end factoring solution that covers your complete accounts receivables, you’ll receive protection against overextending with customers that may be unable to pay.
The finance company will perform credit checks on your clients before factoring an invoice, so you’re more likely to do business with customers that will pay on time.
Con - Your Customer Will Be Aware of the Financing
Some business owners prefer to keep their financing arrangements confidential. With factoring, your customers will be dealing with the finance company’s collections department.
Con - More Expensive
The additional account management and collections services associated with factoring make it a more expensive solution than discounting.
The Pros and Cons of Invoice Discounting
Pro - Confidential
Invoice discounting can be a confidential funding arrangement. Your customer will deal with your collections department and be unaware of the funding relationship.
Pro - Cheaper
Discounting is generally cheaper than invoice factoring.
Pro - Build Closer Relationships With Customers
With your business responsible for collections and accounts, you may find it easier to build relationships with your customers. Introducing a third party can complicate your business relationships, especially if you don’t choose a reputable finance company.
Con - Smaller Upfront Cash Advance
You will typically receive up to 85% of your invoice’s value upfront. This is lower than the 95% you can receive as an advance in a factoring arrangement.
Con - Harder to Access
You will need dedicated in-house collections and accounts departments with a strong track record of collecting customer payments on time to qualify for invoice discounting.
Which Industries Can Use Invoice Factoring and Discounting?
Invoice finance is suitable for any business that sells to other businesses and offers net payment terms. If your company struggles with working capital due to the gap between raising an invoice and receiving payment, it will be a good candidate for invoice finance.
The following industries can benefit most from an invoice finance facility:
- Construction
- Manufacturing
- Transport
- Storage
- Wholesale trade
- Recruitment and staffing
Read this client story to see how invoice finance powered national and international expansion for Tasmanian spirits producer Strait Brands.
Choosing the Right Type of Invoice Finance for Your Business
The right solution for your business will depend on your unique circumstances.
In general, factoring is more accessible and better suited to small businesses that need to support working capital as they grow. Discounting is typically used by larger, more established companies with an in-house collections team.
One of the key advantages of invoice finance is its flexibility. From selective invoice finance to cover unexpected expenses to a revolving line of credit secured against your accounts receivable, it’s possible to tailor multiple funding solutions to your business’s needs.