At some point, you might have come across the terms invoice financing and invoice factoring, and felt confused about the differences between the two.
To compound the confusion, SMEs, buyers and financiers often use both terms interchangeably.
To top it all off – there are other related terms too, such as invoice discounting; as well as accounts receivable financing, receivable financing, and accounts receivable purchase (ARP).
So which is which? More importantly, which presents the best option for your business?
The good news is that accounts receivable financing, receivable financing, and ARP mostly mean the same thing as they all mainly refer to a type of business loan called receivables financing.
This means you just need to understand the difference between invoice financing and invoice factoring.
SME owners often opt for invoice financing or invoice factoring when they need a quick sum of money to expand the business or start a new contract.
Invoice financing or invoice factoring are good ways of shortening the waiting cycles in between payments.
They constitute arrangements drawn up between two or more parties. These are: the buyer to whom you (the SME owner) sold something and issued an invoice to; you – the SME owner; and the financier that you engage to help you get the money sooner than the timeframe the buyer is typically given to pay (i.e. usually 60 days).
It is a good thing if your buyers are reputable companies or government agencies, as such organizations are not likely to default on payment – this is a big plus point from the financier’s point of view.
However, invoice factoring and invoice financing have one major difference between them: How the buyer makes repayment.
As mentioned, this is a way for an SME owner to get working capital sooner.
This is done by pledging an invoice to a financier in order to get the invoice amount more quickly, instead of having to wait up to 60 days for payment to be made by the buyer.
To the financier, this arrangement constitutes a loan as he is giving you a sum of money immediately. So for example, if you are expecting $10,000 from the buyer in 60 days, the financier gives you 80% of that amount upfront – which is $8,000.
In this arrangement, the SME owner contacts the financier directly. The financier does not have any contact with the buyer.
When you receive the $10,000 from the buyer after 60 days, you then return the loaned amount to the financier with a one-time fee and interest. Note that fees and interest rates vary across different financiers.
Sometimes, invoice financing is also referred to as invoice discounting.
Here are the pros and cons of invoice financing.
Not to confuse you, but this is actually in itself a form of invoice financing – albeit with two major differences.
Firstly, this is a two-way arrangement between the SME owner, buyer and the financier in which payment from the buyer is collected by the financier on behalf of the SME owner.
This is unlike invoice financing, where only the SME owner deals with the financier.
With invoice factoring, the financier buys the invoices from the SME. At the outset, the SME owner has to explain to the buyer how and why this arrangement is being made for transparency.
Secondly, after the financier pays the SME owner 80% of the invoice amount, it then collects full payment from the buyer on behalf of the SME owner, after which it will return the outstanding invoice amount to the SME owner in return for a small collection fee.
Note that these days, most SMEs pledge or sell entire sets of invoices, instead of just one invoice.
Here are some pros and cons of invoice factoring.
Belinda loves thinking about random stuff, and collecting useless bits of facts and trivia. She often roots for the underdog, and believes the world needs more happy endings.