What is Invoice Financing?
Invoice financing is a general term for financing based on the money owed to a business by its customers. The institution providing the financing forwards a percentage of what a customer owes to your business in exchange for a fee. It is a useful tool for maintaining working capital while waiting for customers to pay. There are many different types of invoice financing, but the two most common types of invoice financing are invoice factoring, and invoice discounting. When a business uses invoice factoring, the financing institution forwards them a percentage of the invoice, usually 70-85%. They then collect the money the customer owes and then pay you the remainder of the invoice, charging interest or a fee for their services. One of the drawbacks to this method of financing is that since the institution collects directly from the customer, it reveals to the customer that the business needed short-term funding. In some situations, this can look bad for the business that seeks this kind of financing. Invoice discounting, on the other hand, is more discrete. Similar to invoice factoring, the financing institution forwards a percentage of an invoice, in this case, up to 95%. With invoice discounting, however, the invoice remains in control of your business. You repay the loan (plus fees or interest) in regular installments regardless of whether or not the customer has paid his debt back.
Unlike traditional loans, invoice factoring does not take your credit history into account. Since the financing institution is collecting directly from your customers they will use the credit history of your customer to determine the risk that it will not be paid on time. Invoice discounting works more like a conventional loan. The invoices act as collateral, which the financing institution will take control of if you fail to make payments. Since you are responsible for making the repayments, the financing institution uses both your credit history and that of your customers (to assess the value of the collateral). Since the invoices are acting as collateral invoice discounting has less strict credit requirements than most unsecured loans. However, since there is a risk that customers may fail to pay, as well as your business, the credit requirements are more strict than traditional loans with conventional forms of collateral.
Due to the added risk and administrative cost of dealing with customer debt most forms of invoice financing have higher rates than traditional financing. In most cases, invoice factoring withholds a factoring fee, which usually ranges from 1-5%. The size of the factoring fee is determined by the credit rating of your customer, and whether your factor is recourse or nonrecourse. A recourse factor is a factor which needs to be either repurchased or replaced with a new invoice if the customer does not repay the invoice within a certain time frame. A nonrecourse factor offers the financing institution no such protection. Due to the increased risk, nonrecourse factors have higher factoring fees than recourse factors. Invoicing discounts ask for weekly payments, charging as much as 1% per week in interest, regardless of whether the customer pays their debt or not.
How it Works
Invoice financing is a means of gaining capital based on money owed to you. Different types of invoice financing work in different ways. Invoice factoring works by basically selling the invoices of what a customer owes you. The financing institution in questions forwards a percentage of the cash, usually 70-85%, and collects the customer’s debt themselves. After that debt is collected, they give you the percentage they had withheld minus a fee called the factoring fee. Factoring fees are usually 1-5% depending on the type of invoice factoring and the credit rating of the customer. Since you are not directly responsible for paying back the factor, the financing institution usually does not take their credit rating into account. Invoice discounting functions similarly to a secured short-term loan. The invoices act as collateral, to be collected if you fail to pay off the discounting. You still collect from your customer and are in full control of the collection. Finally, you repay the loan plus interest, usually in weekly installments. Since invoicing discounting yields financing that is smaller and lasts for a shorter period of time, the application process tends to be much quicker. Some businesses get approved on the same day as they apply.
Invoice Factoring vs Invoice Financing
Invoice factoring is simply another kind of invoice financing. While there are many other forms of financing that could be placed under the umbrella term invoice financing, it is usually used to refer to either invoice factoring, or invoice discounting. The primary difference between these two types of invoice financing is who collects the money that the customer owes.
With invoice factoring, the financing institution buys the customer’s debt from your business, which can reduce the risk of the customer not paying his debt, and also cut back the administrative cost of collecting the debt. That being said, invoice factoring limits the your ability to show customer loyalty, and his ability to be discreet about his financial situation. While with invoice discounting, you use invoices as collateral to secure financing. This gives you control over your invoices, but puts you at risk if your customer never pays their debt.
This change in structure also alters the credit requirements and the repayment schedule of the two types of financing.