Invoice Financing vs Invoice Factoring
Bill financing allows you to borrow against outstanding bills. Factoring sells invoices to factoring companies at discounted prices.
Small businesses that need to manage liquidity issues or cover short-term expenses may consider using invoice financing and invoice factoring. Both types of financing allow you to access the capital of your business using outstanding invoices.
Invoice finance and factoring are often confused, but the two products differ in their structure and repayment process. Everything you need to know is here.
What is Invoice Financing?
Invoice financing, also known as invoice discounting or accounts receivable financing, refers to borrowing against outstanding accounts receivable. Lenders will advance a portion of your outstanding bills (up to 90%) in the form of a loan or line of credit.
When the customer pays the bill, we return the amount borrowed plus fees and interest to the lender. With invoice financing, the company is responsible for collecting any outstanding amounts from the customer.
In some cases, the invoice finance company synchronizes behind the scenes with the accounts receivable system. When the customer pays the bill, the financial company may automatically deduct a fee before transferring the balance.
Invoice Financing Example
Let's say you're funding a $50,000 invoice with a 30-day term. Find the invoice from your lender and pay 80% or $40,000 up front.
The lender will charge $3 for each month the bill is unpaid. Your customer pays within the month, so you keep his $8,500 and repay the lender his $41,500 — originally his $40,000 plus his additional $1,500 fee.
Overall, you received 97% of the bill ($48,500 out of $50,000) and the bill financing company received a $1,500 fee. This gives an effective annual interest rate of 45%.
What is invoice factoring?
Invoice factoring, also known as accounts receivable factoring, sells outstanding invoices to a factoring company at a discounted price. The Company prepays a portion of the invoice amount and is responsible for collecting the full amount.
Once the company has collected the full repayment from the customer, it will send the difference minus the agreed fees. Unlike invoice financing, in invoice factoring, the customer pays the factoring company instead of paying the factoring company directly.
Examples of calculation factors
Suppose he sends a customer an invoice for $50,000 with a 30-day repayment period. I need the money immediately, so please contact the invoice factoring company. The company purchases an invoice and prepays $42,500, which is 85% of the amount.
The factoring company charges €1 for each week it takes for the customer to settle the invoice. The customer pays the company 4 weeks after her. The company will deduct a 4% fee ($2,000) and send you the remaining $5,500.
Overall, we received 96% of the invoice, which was $48,000 of the original $50,000, and the factoring company received a $2,000 commission. This gives us an APR of approximately 56.47%.
Benefits of invoice financing and factoring
Suitable for business-to-business companies. Both invoice financing and invoice factoring are ideal for B2B businesses that have cash flow problems due to unpaid invoices. Get quick access to capital before you pay your bills.
Flexible requirements. Compared to other types of business loans, it may be easier to qualify for invoice finance or invoice factoring, even if your business is a start-up or has a lower credit rating. Lenders can prioritize invoice value and customer payment history when evaluating applications.
Disadvantages of invoice payment and factoringIt can get expensive. Businesses can charge fees in a variety of ways, but generally they pay a percentage of the invoice amount (a total of 1% to 5% per month) for either invoice financing or factoring. Factoring these fees into the APR shows that it can be particularly expensive when compared to other forms of financing such as bank loans, which typically have interest rates ranging from 2.54% to 7.02%.
Depends on customer payment. With both accounts receivable factoring and invoice financing, the final fee depends on how quickly the customer pays the invoice. This structure makes it difficult to estimate funding costs in advance. In addition, delays and additional charges can occur when customers delay or fail to pay their bills. Also, if a customer does not pay at all, they will almost always be held accountable for the debt. Some factoring companies offer true factoring where the company accepts losses if the customer does not pay. However, this type of financing is usually not offered with a discount on the bill, but is usually the more expensive option.
Invoice financing and factoring:What is right for my business?
Invoice factoring is a good option for businesses that don't mind abandoning invoice control and allowing factoring companies to collect payments from their customers. This is especially useful for small businesses that don't have the resources to keep track of invoices.
If you are a new business or have low credit, factoring may be easier to qualify as it depends on the credit profile of the customer. However, higher charges may apply.
Financing by invoice, on the other hand, is a better option for businesses that want to manage their accounts receivable. Invoice rebates can be a quick and inexpensive way to raise funds, especially if you have a strong customer relationship and can collect outstanding invoices quickly.
Find and compare small business loans
If neither know your invoice financing or factoring are right for you, check out NerdWallet's list of the best small business loans for business owners.
Our recommendations are based on an analysis of market size and lender performance, business owner needs, interest rates and other factors to help you make the right financing decisions.