Invoice Financing vs. Factoring: What Are the Differences?

Although SBA loans and bank term loans can fulfill most traditional small business needs, some borrowers may prefer loans based on their future cash flow. Such entrepreneurs often turn to invoice financing, which you might often mistakenly see referred to as invoice factoring. In reality, these two funding types aren’t the same, though they do have quite a few similarities. Below, learn more about the big invoice financing vs. invoice factoring question.

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What is invoice financing?

Invoice financing is the process of borrowing money against your outstanding invoices. You’ll present the sum of your accounts receivable – and the invoices underlying it – to a finance company.

You’ll occasionally see invoice financing referred to as “invoice discounting,” though “invoice financing” is the more widely used term. It’s also more accurate: Your clients don’t receive a discount on what they owe you if you obtain funding through invoice financing.

Your finance company will lend you approximately 80 percent of your unpaid invoice amount. You can obtain this funding as a standard business loan or as a business line of credit. It’s then your responsibility to obtain customer payment. Once the customer pays, you’ll subtract the amount you were lent from the total of your invoices. A portion of that difference will go to the finance company as fees and interest.

As an example, let’s say you invoice a client $20,000 due in 30 days. Let’s also say you need an additional $15,000 to cover payroll. You would have that money if your invoices were paid, so you bring this invoice to a finance company. This company immediately gives you a large percentage of the invoice – say, 80 percent, or $16,000. You can now cover payroll while pursuing invoice payment yourself. Part of the $4,000 left will go to the financier when collected.

What is invoice factoring?

Invoice factoring and invoice financing are similar, except there’s one big difference between the two. An invoice factoring company funds you and deducts fees in the same way and takes over your collection process. That means you won’t have to take the time to pursue clients for payment, though you’ll pay extra to cover collection costs. It also means you introduce a previously uninvolved third party into the payment process, which some clients may find concerning.

You’re best off reserving invoice factoring for older invoices or clients who often fail to pay. For example, let’s say your $20,000 invoice is due in 60 days and you need $15,000 now. You might then send this invoice to a factoring company, which pays you 90 percent ($18,000) of the invoice upfront. It also takes over your collection process. When the client does pay, the factoring company will forward you the remaining $2,000 minus higher fees.

Differences between invoice financing vs. factoring

Small business owners should understand certain key differences between invoice factoring and financing before deciding which option is right for them. These differences include:

1. How much money you can borrow

Typically, an invoice financing company will pay you 80 percent of your invoice upfront. Invoice factoring companies will pay you more – somewhere between 85 and 90 percent. Though these differences can be minuscule for small invoice amounts, you could be looking at tens of thousands of dollars more for larger invoices.

2. Fees

Invoice financing and factoring companies both charge percent-based fees on a monthly basis. You’ll pay one to three percent of your invoice’s value per month if you choose invoice financing. That rate increases to between two and 4.5 percent per month for invoice factoring. The latter’s higher fees reflect the additional invoice collection services unique to factoring.

3. Invoice ownership and collection

When you obtain funding through invoice financing, you retain ownership of your accounts receivable. Going with invoice factoring gives the company full ownership of all your invoices instead. That’s how invoice factoring companies get permission to pursue your invoices on your behalf. If you own your invoices, only you have the legal right to pursue them, so factoring companies must buy your invoices to do their job.

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Pros and cons of invoice financing and factoring

You might get the hint from all the above that invoice financing and factoring aren’t too different overall. That would be correct – and it’s why invoice factoring and financing have nearly the exact same pros and cons, which are detailed below.

Pros of invoice financing and factoring

Invoice financing and factoring are great if you need to:

  • Free up your cash flow. The above examples of invoice financing and factoring reflect common scenarios. Namely, small business owners often use invoice financing and factoring to rapidly free up their cash flow so they can cover other expenses. If you need cash in a pinch for any recurring expense, you can reliably finance your invoices if you’re confident your clients will pay them.
  • Easily qualify for funding. Many high-quality business loans such as SBA 7(a) loans and bank term loans enforce tough qualification criteria. For example, low credit scores often don’t fly with the lenders behind these loans. That’s not quite the case with invoice factoring and financing, where the details of your invoice matter more than your business and financial history.
  • Obtain funding at a low price point. Invoice factoring and financing fees range from one to 4.5 percent. If your client pays you back quickly, these rates can be lower than the interest you pay on certain small business loans. That means you borrow money to obtain working capital at a lower price point – and more quickly – than with traditional loans.

Cons of invoice financing and factoring

As with any funding route, invoice financing and factoring have their flaws. Here are the major disadvantages of both.

  • Can be expensive. Invoice factoring and financing are only inexpensive if your clients pay your invoices quickly. If not, you’ll pay the same fee each month on an amount that, unlike with amortizing loans, doesn’t decrease. For example, let’s say you go three months without a client repaying a $20,000 invoice you’ve factored. If the factoring company charges 4.5 percent per month, that’s $20,000 * 0.045 * 3 = $2,700 in fees. The result is effectively a fee of 13.5 percent – way more than with other funding types.
  • Can be indiscreet. Not all factoring companies’ invoice collection agents take steps to appear as though they’re employees of your company. That can be problematic for two reasons. One, most clients will feel like they’re being needlessly pressured – maybe even harassed – if a third party enters the mix to collect invoices. Two, some clients may perceive your use of invoice factoring as a sign that your business is in financial peril. That can cause them additional concerns about working with your company.

Apply for invoice financing with SmartBiz®

Invoice financing and factoring are great options if you need fast cash through a funding route you can confidently repay in the future. Of the two, invoice financing is typically lower-risk, and you can obtain it through SmartBiz. Check whether you pre-qualify* with SmartBiz – we’ll pair you with someone who can explain all the intricacies at every step of the way.

*We conduct a soft credit pull that will not affect your credit score. However, in processing your loan application, the lenders with whom we work will request your full credit report from one or more consumer reporting agencies, which is considered a hard credit pull and happens after your application is in the funding process and matched with a lender who is likely to fund your loan.

WHAT YOU NEED TO KNOW: The SmartBiz® Small Business Blog and other related communications from SmartBiz Loans® are intended to provide general information on relevant topics for managing small businesses. Be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed. Please consult legal and financial processionals for further information.

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