Invoice Financing vs. Invoice Factoring: What’s the Difference?

Learn the difference so you can decide which is right for you.

Outstanding invoices can be frustrating for small businesses. Although you know that the money for the invoices will get repaid at some point, if you have customers who are slow to pay or have long repayment terms, your company’s cash flow could be seriously disrupted. Cash flow and working capital are frequently cited by small business owners as one of their principal challenges. Unpaid invoices only serve to augment these challenges.

Fortunately, there are some options available for dealing with unpaid invoices. What’s more, you can use your unpaid invoices to actually secure funding for your business, such as for working capital needs. There are two notable forms of funding that are based on outstanding invoices:

Both can provide quick funding using your invoices as collateral, but they’re also distinct from each other. Read on to find the differences between invoice financing and factoring, and how you can use them to help get the money you need for your business.

What Is Invoice Financing?

Invoice financing is sometimes known as accounts receivable financing. The basic mechanism for how it works is based on the idea of your business expecting money to come in as represented by having an outstanding invoice. If your company offers extended credit terms to customers — between 30 and 90 days — invoice financing lets you use your invoices as financial proof that you will be able to pay the lender back on a loan. Thus, in invoice financing or accounts receivable financing, your outstanding invoice acts as the collateral to secure you a line of credit or loan. The amount of your line of credit is determined based on the value of your invoices.

With invoice financing, you can typically get up to 85% of your invoice upfront from the lender. Once your customer pays the invoice, you then pay the lender back. What’s great about this is that it prevents you from having to wait to get your money, which is especially important if you need working capital.

Related: 5 Best Free Accounting Software Options

What Is Invoice Factoring?

Invoice factoring is also sometimes called accounts receivable factoring. Like with invoice financing, with invoice factoring, your unpaid invoices are the basis for your getting money from a lender. In the case of invoice factoring, the company that gives you the loan is called the factoring company or a factor. Your business sells your outstanding invoices to the factoring company, which then provides an upfront payment that is usually 85% to 95% of the invoice total.

Since you sell your invoices to the factor, it is the factoring company that then collects payments from your customer or customers. When your customers have paid their invoices, the factoring company then pays you the remaining balance, after the factoring fee is taken out. Typically factor fees range from 1% to 6% per month, but these terms, of course, can vary depending on the factoring company and your business. Since the factoring company charges the factor fees on a monthly, weekly or even daily basis, the longer it takes for your invoices to get paid, the higher the fee you’ll pay.

Invoice Financing vs. Invoice Factoring: What’s the Difference?

There are some superficial similarities between invoice financing and invoice factoring, such as your unpaid invoices serving as collateral for the funds you receive. However, there are some fundamental differences you must be aware of before choosing either option.

The biggest difference is that, with invoice financing, your business is the one who collects payment on your outstanding invoice. With invoice factoring, your business sells the unpaid invoice to a factoring company who then collects the invoice payments directly from your customers. Depending on you, your business and situation, this could be a major drawback since it separates you from your customers. Though your customers might not care or even notice that their invoices are being collected by another company, in other ways they may care, especially if your business has established a good rapport or personal relations with your customers. Bringing in a third-party factoring company to collect payments could be off-putting.

There are other, subtler differences between invoice financing and invoice factoring. Below is a table that breaks down some of the important variations in flexibility, costs, invoice payment and confidentiality.

Description Invoice Financing Invoice Factoring
Invoice Payment Terms You have more flexibility and get to choose which invoices to finance and when to do it You generally have less flexibility and invoice amounts are advanced in the order received
Cost Monthly rate typically between 3% and 5% that depends on the amount of your invoices Higher fees that can be as much as 15% of invoice amount for selling a single invoice; you usually get lower fees for longer-term commitments
Receiving Funds Invoices serve as collateral for a line of credit Invoices are sold to factoring company for immediate cash
Collecting Invoice Payments Your business still collects invoice repayments directly with your customers The factoring company will usually collect payments directly from your customers or have a debt collection service do it on your behalf
Confidentiality Generally, your customers won’t know you are using a financing company Usually less privacy since customers will be aware you are using a factoring company when contacted about payment from the third-party

When Does it Make Sense to Do Invoice Financing or Invoice Factoring?

One of the most notable advantages of using invoice financing or invoice factoring is the speed with which you can receive funding. What’s more, many businesses that may not qualify for traditional business term loans from a bank, let alone an SBA loan, can get the funding they need through invoice financing or factoring. Generally, most business loans have requirements such as a certain time in business and minimum annual revenue generation, as well as the personal credit score of the owner and business credit score for the company, if it has a credit profile. However, if your business is operating and generating legitimate accounts receivables, then invoice financing and factoring could be an ideal method of funding instead of going the traditional route.

Though invoice financing and factoring don’t have rules and terms as strict as traditional business loans, your business could still disqualify itself. If your business’s revenues are too low, your business has just started out or if your personal credit score is especially poor, then you might not be able to use invoice financing or invoice factoring. Ultimately, your company does need to be successfully generating business in order to get financing through your invoices.

An important factor to consider when deciding whether to pursue funding through your invoices are the fees. Invoice financing typically has lower fees than invoice factoring and the factoring fees reduce the amount you receive from your invoices. You’ll have to weigh the necessity and urgency of receiving funds with the amount you’ll be charged in fees. If you’re not in immediate need of funding, then waiting for an outstanding invoice to be paid might make sense. But if you need a lump sum of cash immediately, then invoice factoring could make a lot of sense. If you want a line of credit using your invoices, then pursuing invoice financing is a good move. It all depends on your personal situation.

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