Factoring vs. Invoice Discounting: Key Differences Explained

 

FACTORING

 What is Factoring?

Factoring occurs when a business (the Client) sells its outstanding invoices (book debts) to another business (the Factor) for immediate cash. The Factor then collects the payments directly from the debtors.

 Benefits of Factoring

• Improved Cash Flow: Clients get most of the invoice value quickly, allowing them to pay suppliers in cash and possibly negotiate discounts.
• Risk Reduction: Factoring can provide protection against debtor defaults, reducing the need for credit risk insurance.
• Reduced Administration: Factors can take over debtor ledger management, reducing administrative burdens.
• Alternative to Loans: Provides more funding than loans, especially for businesses with large debtor books, though often at a higher cost.

 Pre-Conditions to Factoring

• Goods/services must be delivered and accepted without disputes.
• The company should be profitable and have a clean credit record.

 Purchase Price

• Typically, the Factor pays the invoice value minus a retention for bad debts (10%-25%).
• The Client pays a fee and interest on amounts advanced.

 Types of Factoring

• Confidential Factoring: Debtors are unaware of factoring.
• Non-Confidential Factoring: Debtors are informed and pay the Factor directly.
• Recourse Factoring: Client bears the risk of non-payment.
• Non-Recourse Factoring: Factor bears the risk of non-payment.

 Security

Factoring agreements include suretyships and pledges to protect against bad debts and insolvency.

 

INVOICE DISCOUNTING

 What is Invoice Discounting?

Invoice discounting involves a business (the Client) borrowing money against its sales invoices from another business (the Invoice Discounter). The Client retains control of the sales ledger, and the debtors are unaware of the arrangement.

 Features

• Clients can draw up to 80% of the invoice value immediately.
• Clients manage invoicing and credit control.
• The Invoice Discounter charges a fee and interest on the advanced amount.

Benefits of Invoice Discounting

• Improved Cash Flow: Provides immediate cash like factoring.
• Flexibility: Interest is only paid on borrowed funds, akin to an overdraft.
• Confidentiality: Can be arranged without customers and suppliers knowing.

 Drawbacks

• Perception Issues: May signal financial distress, affecting supplier credit terms.
• Cost: More expensive than loans or overdrafts.
• Asset Reduction: Fewer assets available as collateral for other loans.
• Dependence: Difficult to leave once reliant on improved cash flow.

Example

ABC factory sells shoes to a retail shop with 90-day credit. To get immediate cash, ABC can either factor or discount the invoice, receiving up to 80% of the invoice value upfront. When the retail shop pays after 90 days, the remaining amount, minus fees, is paid to ABC.

Conclusion

Factoring and invoice discounting both provide immediate cash from sales invoices but differ in terms of debtor management, confidentiality, and risk handling. Factoring involves selling the debt and the Factor managing collections, while invoice discounting involves borrowing against invoices without debtor involvement.