Invoice Financing vs Factoring: Decoding Key Differences for Small Businesses

The essential difference between factoring and accounts receivable (AR) financing lies in the handling of invoices. Factoring involves purchasing your invoices at a discounted rate, while AR financing or asset-based lending uses the invoices as collateral for a working capital loan.

As a small business owner, you've likely encountered terms like 'invoice factoring', 'AR financing', and 'invoice financing' frequently. These terms may often be used interchangeably by business owners and financiers, but they're not identical. While both methods provide quick access to working capital for small businesses, they operate differently. Traditional banks, for instance, don't usually offer true AR factoring as they don't buy the invoices, rather, they use them as collateral for working capital loans. Here are some crucial differences between these two popular invoice financing methods.

Factoring Companies Buy, Banks Offer Loans
Just like a factoring company, a bank will evaluate your current accounts receivable and select the ones they will accept as collateral for a small business loan. If they're not satisfied with a customer's repayment terms or speed of payment, they might not accept those accounts receivable as collateral. A factor, conversely, is typically more flexible in the invoices they accept but may charge slightly higher fees for late invoice payments. Importantly, since factoring isn't considered a loan, it won't impact your debt utilization or debt-to-equity ratio. A bank loan, however, will have potential repercussions based on your current debt situation.

Factoring Companies Pay 97% to 99%, Banks Offer Loans of 75% to 85%
Factoring companies usually advance around 75% to 95% on the invoices they factor, keeping the remaining amount in reserve. As your customers pay their invoices, the factor returns the reserve to you. After all payments are collected and the factoring fee (usually 1% to 3%) is deducted, you typically end up with 97% to 99% of your total accounts receivable. In contrast, most banks only lend 75% to 85% of your invoices' value and charge an interest rate on the loan amount, which is usually higher than other types of traditional business bank loans, like SBA small business loans.

Factoring Companies Assume Payment Collection Responsibility; Banks Don't
When a factoring company purchases your invoices, it takes on the responsibility of collecting payments. This can save your business money by reducing the need for your own staff to manage the accounts receivable process. Banks, on the other hand, don't perform accounts receivable tasks, meaning you need to deploy and pay your team to collect the invoices. Many factoring companies also offer credit protection, meaning they, not you, bear the risk if a customer fails to pay or declares bankruptcy before the invoice is settled. Unlike factors, banks don't offer credit protection as you still own the accounts receivable invoices.

Both these financing methods can help your small business operate more efficiently. If you're considering either option and need further information, feel free to reach out. We can provide insights into the pros and cons, helping you make an informed decision tailored to your specific business needs.

Common Misconceptions About Factoring
Many entrepreneurs who haven't utilized accounts receivable factoring might have certain misunderstandings about it, ranging from transaction details to the types of businesses that can leverage factoring for working capital. Here are some common misconceptions clarified.

Is Factoring a Loan?
No, factoring is a sales transaction, not a loan, even though it functions as a financing strategy. The funds can be used as cash from a credit loan or small business loan, but factoring doesn't show up on your balance sheet as debt. Therefore, it doesn't create a liability or affect your debt-to-equity ratio unless you use the funds to pay off debts. The factor essentially purchases your invoices and advances 70 to 90 percent upfront, with the remainder after the invoice payments are collected, less the factoring fee which typically ranges from 1 to 3 percent.

Is Factoring an Expensive Form of Finance?
It depends on your situation. If you utilize the funds to grow your business or eliminate payroll expenses for accounts receivables, factoring can indeed be cost-effective. Factoring companies generally handle your accounts receivable tasks. For instance, they examine your customers' credit, collect invoice payments, and provide you with financial reports detailing your receivables status. While rates might be higher than some low-interest business loans or SBA loans for small businesses, the cost is irrelevant if you don't qualify for the loan. Hence, consider the cost of not having the necessary cash to grow your business through funding acquisitions, implementing marketing and promotions, or purchasing more inventory.

Is Factoring Only for Businesses About to Go Under?
Factoring is a popular financing strategy for rapidly growing businesses. Some newer companies that lack an established credit history or financial ratios that qualify them for traditional bank loans use factoring funds to increase their sales volume, total profits, and capitalize on early payment discounts from suppliers.

Is Factoring a Long-Term Arrangement?
While many businesses use factoring as an ongoing financing strategy, a long-term commitment isn't required. Some businesses use it as a short-term strategy to improve their financial standing for a traditional bank loan, navigate seasonal supply and demand issues, kick-start growth, acquire other businesses' assets, or expand operations.

More Concerns About Factoring
Here are answers to some of the most frequently asked questions about factoring, assignments, billing, and posting of your accounts receivable invoices.

1. Do I lose control of my billing and posting?
No. You continue to create your invoices, and the factoring company posts the payments when they get paid. The factor provides you with a posting report, and often you can view the paid and outstanding invoices daily online.

2. What if a payment is made on an invoice I did not factor?
Even if the payment is sent to the factor, you still receive 100% of the payment. If the invoice was not factored, the factor simply passes on the payment to you and no fee is charged.

3. How often can I factor my invoices?
You determine your factoring schedule based on your cash-flow needs and your invoices. There is no restriction on how frequently you can factor if you have a verified invoice for goods and services provided.

4. Can I qualify for factoring with a compromised credit history?
Yes. Most factoring companies look at your customers' credit history to determine their payment behavior. This helps them estimate when they will receive payment on the invoice. Your personal credit history is usually not considered.

5. How Long Does it Take to Get Funded the First Time?
You can pre-qualify over the phone, and submit an application and necessary documentation. Once you submit the required paperwork to the factoring company, it can take as little as 24 hours to get funded. Normally, the funds are wired to your account electronically.

6. Can I choose how many invoices to factor?
Yes. We can provide a facility with no minimum requirements. Simply let us know your preference. Based on your dollar value, it may be advantageous to choose a factoring company with minimums if you plan on factoring for a long time. You may gain access to better rates by doing so. We can help determine what is best for you based on your specific situation, but ultimately you will decide what works best for you and your company.

If you need additional information or assistance in considering these financing options for your business, feel free to contact us. We can provide guidance in weighing the pros and cons based on your business's unique circumstances.