If you are looking to improve your business cash flow then invoice factoring or discounting maybe the perfect solution. Compare the lenders and finance solutions below or speak with a commercial finance broker for guidance and to obtain a no obligation quote.
What is invoice discounting and factoring?
Invoice factoring and invoice discounting are related methods that businesses use to raise short and medium term funding. Via these methods, a business can work with a third party organisation to raise funds using the value of its outstanding invoices as leverage. For many businesses, it’s an efficient and flexible way of obtaining working capital, and has several advantages over using a loan or overdraft as a source of funds.
How discounting and factoring works
While there are some key differences between invoice discounting and factoring, the basic processes are the same. In each case, a business enters into an agreement with a third party provider. Under the terms of the agreement:
1. A business invoices clients for goods or services and at the same time submits a copy of the invoice to the third party provider.
2. Within 24 hours, the provider pays the business up to 85% of the value of the invoice.
3. Once the customer pays the invoice, the money is returned to the provider, along with interest and an additional servicing fee.
4. The balance of the invoice is paid to the business.
For example, a business submits an invoice to a customer for £10,000, and within 24 hours receives £8,500 from the invoice discounting provider. Once the customer pays the invoice, the provider receives £8,500, plus interest and a servicing fee. The remainder of the money goes to the business. In the case of factoring, the customer pays the factor, and the factor pays the business the balance of the invoice.
How are invoice discounting and factoring different?
The key difference between invoicing and factoring is how the business’s sales ledger and debt collection is managed. With factoring, the third party provider takes over the management of a business’s sales ledger and the collection of customer invoices. In contrast, with discounting the business retains control of its sales ledger and collects on its invoices. This is why the process is slightly different depending on whether factoring or discounting is involved.
In addition, factoring and discounting tend to be more appropriate for different kinds of businesses, not necessarily in terms of the industry, but in terms of how a business operates. For example, invoice discounting usually requires a higher annual turnover than factoring: in most cases, a minimum of £500,000 for discounting versus £50,000 to £100,000 for factoring. Other requirements for invoicing also tend to be more stringent. For example, discounting providers typically want to audit a business’s books each quarter, and require that a business be profitable and have a minimum net worth of approximately £30,000. Discounters and factors may also have requirements in terms of the number of different clients a business has, with a preference for businesses that don’t rely on a small number of clients to stay profitable.
The reason for these differences is largely because the risks to the third party provider are higher for discounting than they are for factoring. Because the provider doesn’t take control of invoice collection, they have more rigorous requirements in terms of the business’s profitability, turnover, and net worth.
What kinds of businesses use factoring and invoice discounting?
These methods are used in a wide range of industries, most specifically in industries where invoices are for large sums of money, and payments are not made instantly on provision of goods or services. This is because factoring and discounting are inefficient processes when they involve large numbers of invoices for small amounts of money. Therefore, while factoring and discounting aren’t a feature that is commonly used by retail outlets, these methods are often employed in manufacturing and construction, as well as by printers, couriers and wholesalers.
In addition to this, factoring and discounting can benefit businesses in other industries, depending on the situation. For example: start-ups that want to take advantage of flexible financing options; growing businesses that want to maximise their cash flow; and struggling businesses that have trouble bridging the financial gap between invoicing a customer and receiving payment.
How businesses can benefit from discounting and factoring
Using factoring and discounting services has some important advantages for businesses.
• The ability to receive payment for goods and services before customers actually pay provides businesses with a highly flexible way of managing working capital and maximising cash flow
• Up to 85-90% of the value of outstanding invoices can be advanced, whereas securing an overdraft against unpaid invoices can typically raise a maximum of 50% against the value
• These methods have an additional level of flexibility, in that a business negotiates an initial credit line with the third party provider, but can arrange to have their credit limit increase as their sales increase. In contrast, negotiating increases on overdrafts and loans is typically a less flexible process that can take some time to arrange.
• Using a factor can reduce the amount of time and money a business must spend on debt collection (note: this doesn’t apply to invoice discounting, where the business retains control over its sales ledger)
• Export factoring can help a business reduce the risks and costs associated with doing business internationally, and the costs of this kind of factoring are comparable to the costs of similar kinds of financing
Are there any drawbacks?
For the most part, factoring and discounting are highly advantageous services for businesses, but there are a few disadvantages and limits that it’s important to understand.
One of the most significant, of course, is that a small portion of each invoice is paid to the third party provider as a fee and/or interest payment. However, this fee is comparable to the costs involved in alternative methods of financing, such as an overdraft.
In terms of factoring, there may be some additional constraints; for example, some factors may want to pre-approve new customers, or set credit limits for some customers, which may delay or limit some business dealings.
Another potential issue with factoring is that some business owners aren’t comfortable giving up control of their sales ledgers, and some customers aren’t comfortable dealing with a factor. However, when factoring is implemented carefully and with plenty of consideration for these potential problems, it can make the process go very smoothly.