Factoring receivables can be a fast and effective way to obtain capital for your growing small business. Accessible to almost every business regardless of number of years established, credit history, or profitability, factoring can provide your business with regular cash infusions for your invoices. It is suitable to a wide range of industries, including manufacturing, oil & gas, energy, trucking, freight & transportation, information technology, telecommunications, business services and more. Large, reputed businesses with high dollar value invoices are ideal clients for factoring invoices. However, it is also something that can benefit small businesses and startup companies.
Though it is an eons-old form of commercial financing, factoring accounts receivables is new to many businesses. Many of its practices, terminologies, and processes sound confusing and unfamiliar. Part of this is because within the larger umbrella of factoring, there are several different types of factoring services each with their own set of rules and conditions.
What is the General Definition of Factoring Receivables?
In its most basic terms, factoring accounts receivables is the process of selling your valid and most recent invoices to a third-party invoice factoring company for approximately 80-93 percent of their face value. (This percentage will vary based on the industry.) The factoring company will decide whether or not to purchase the invoices and for how much based on the client’s creditworthiness and history. So instead of relying upon your company’s credit history, the credit of your client is relied upon. The client’s creditworthiness — not your company’s — drives the factoring process. This is true for all different types of factoring.
So in a nutshell both financing options involve the factoring company buying up valid client invoices in exchange for providing an advance on invoice payment to your company. Since they are both the same in this fundamental manner, how are they different?
The Details on Debt Factoring
An international term for invoice factoring or invoice financing, this is the more traditional or standard form of factoring. It is often viewed as the full-package option and is generally more expensive than invoice discounting. Companies that have transactions valued at more than $350,000 per month tend to choose debt factoring. These companies are likely to include industries that have a long history of using such third-party financing options, including manufacturing, transportation, wholesaling and distribution, textiles & apparel and more.
View Debt Factoring as Concierge-level Financing
Accordingly, debt factoring includes a lot of bells and whistles that the discounting option does not. In this case, the factoring company manages the entire collections process including all back-office account receivables’ functions. This can be a significant benefit for your company that is seeking the financing because it allows your company to focus its time and resources on more revenue-generating business activities.
It is also significant to note that with debt factoring, the invoice factoring company performs the credit check and verification of the client. As a result, in many cases, the factor itself will absorb the debt should it go unpaid by the client because it verified that the client was creditworthy. Depending on the industry or circumstances, this can be an important consideration for those businesses weighing their financing options. With invoice discounting, the factor does NOT take the loss; this burden goes back to you, the small business owner.
There’s No Expectation of Confidentiality with Debt Factoring
It is also worth mentioning that with debt factoring, your clients are generally aware that you are using a third-party commercial financing company to process and advance invoice funding. Quite simply, they will know because they will remit payment directly to the factor and so they may notice this change on the address.
In addition, for these high volume enterprises in industries such as manufacturing, transportation, freight, and others, using a third-party finance company to handle accounts receivables is more the norm than the exception. Most likely, your client won’t think anything of it and if they do, the factoring company will explain the processing and it is unlikely to be a concern.
All About Invoice Discounting
Invoice discounting is the more frill-free form of factoring that is solely about the transaction itself, the advancing of the capital from the value of the invoice. As such, it does not offer all the little extras – collections and back-office account receivable functions — of full-service debt factoring. Perhaps more significantly, the company that issues invoice discounting factoring services relies on you to verify the creditworthiness of the client.
If they are a long term client you have worked with for years, this may not be a problem. Yet if this is a new client that hasn’t been in business too long, this becomes a riskier endeavor. For better or worse, with invoice discounting the risk of non-payment or loss rests solely on your company’s shoulders.
Startups Can Reduce Expenses with Invoice Discounting
As the name implies, a significant difference between the two options is cost. Because you are doing much of the legwork yourself – you are not out-sourcing collections, accounts receivables, or credit verification services – the cost of invoice discounting is less than the cost of full-service debt factoring.
This is another reason why many start-up or early stage businesses tend to prefer invoice discounting. In this way they get the benefit of fast cash and still retain complete control over their back office accounting functions. Because they are a small firm, these responsibilities are more manageable and therefore the need or desire to outsource them may not yet exist.
Invoice Discounting Services Are Generally Confidential
With the invoice discounting choice, because you are handling all of the back-office account receivables and processing functions, the client remits the invoice to you in the same way that they always have. As such, there is no reason for them to think you are using a third-party company to advance payment. This way, your client, who may or may not know what factoring receivables services are, does not know you are partnering with a factoring company. For these reasons and more, invoice discounting may be the better option for start-up or early-stage businesses who conduct monthly transactions of $100,000 or less.
A Summary of Debt Factoring and Invoice Discounting
When choosing between these two choices, it really comes down to: size of monthly transaction volume, need of add-on services, and cost. If you are an early-stage, low- to-mid-volume company that needs the capital and doesn’t mind handling accounts receivables duties in-house, invoice discounting may be the best, cost-effective choice. Yet if you are a large established firm looking to boost monthly cash flow and doesn’t want to deal with the hassles of processing invoices, full-service and convenient debt factoring may be the better choice.