Factoring vs. invoice discounting

Both factoring and invoice discounting can be described as ways to obtain immediate cash by selling accounts receivable to a third party, typically a finance company. In fact, the two methods are more similar than different.

Factoring, also known as asset securitization, is a direct sale of accounts receivable to the finance company. The company gets cash, and the finance company collects the debt, keeps the interest, and gets a discount fee on top of that for their troubles. Invoice discounting can also be called the sale of accounts receivable, but in this case the administration of accounts receivable and its collection does NOT change hands. The business that earned the revenue still has that responsibility.

Here are some questions to consider in choosing which method is best for your business:

1. Are you concerned about the cost of collections in your company? Is it getting out of hand? Does your collection area have competent and reliable personnel? If you think your business would be better off reducing the amount of resources devoted to this function, factoring is the best option for you, since much, but not all, can be transferred to the finance company. If you already have a well-functioning collections department, you can choose invoice discounting. That way, your staff and procedures regarding collections will remain in place.

2. Knowing that the finance company will undoubtedly treat its clients with the utmost courtesy, respect, and professionalism, are you concerned that you would prefer to deal directly with your company? Perhaps billing requests often come along with customer service requests. Typically, your customer is unaware of the sale of their account receivable to you with the invoice discount. Not only are you aware of a factoring agreement, but you are also subject to individual invoice confirmation calls from the finance company on occasion. If this is something you know would upset your customers, you may want to choose invoice discount.

3. What are your current information needs regarding collection efforts and your clients? Are you currently collecting this data and relying on it to make future credit decisions for this customer? Can the finance company provide it in the format and frequency you want? If not, invoice discounting may be the right choice, leaving all your current data collection techniques unaffected.

4. What are your cash needs? Whether with factoring or invoice discounting, you’re paying for immediate cash. Cashing out yourself at a normal rate would return you more actual cash. But invoice discounting returns you more cash than factoring. This is obviously due to the fact that the financial company assumes more responsibilities and duties with factoring than with invoice discounting.

5. How large is your company’s portfolio of unsecured accounts receivable? How diverse is it? Does any individual customer own more than 20% of the total accounts receivable balance? In general, companies that use invoice discounting tend to be larger and have a more diverse portfolio. However, this could be why they chose bill discounting over a feature. They already have collection efforts and data collection methods in place, and the cost and difficulty of changing them can be prohibitive for a factoring arrangement. Portfolio diversity is something financial companies look for in both deals.

Making an honest assessment based on these factors will help you make the right decision for your business. You’ll soon be on the path to healthy cash flow, no matter which one you choose.

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