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Factoring and invoice financing can both help with cash flow but it’s crucial to understand the difference.
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How to maximise the potential of unpaid invoices
14 July 2023
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12 minute read
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If you’re a business owner in the US, UK or Europe there’s a high chance that you’re using invoice financing – an advance on money owed from your outstanding invoices like a revolving line of credit to help with cash flow.
But in Australia it’s estimated that less than 13 per cent of eligible businesses are taking advantage of this type of asset-based funding. Despite growing popularity, there are still some myths and confusions about invoice financing.
With traditional bank financing being harder to come by and businesses looking for alternative funding options, it’s time owners educated themselves about the options available.
There’s a common misconception that invoice financing is the same as factoring. Both invoice financing and factoring are suitable for B2B companies and involve helping business cash flow and providing a way to access cash quickly by using their unpaid invoices as collateral. However, they are very different financing tools and it’s important to know the difference when looking at them for your business or to advise clients of their options.
What is factoring?
Factoring is a financing option where a business sells its unpaid invoices to a factoring company, and in exchange the factor pays the business a percentage of the value of the invoice upfront, typically 70 to 90 per cent.
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The factoring company then takes responsibility for collecting payment from the customer directly and keeps the difference between the price paid to the business for the sale of its invoices and what it is able to collect.
Because the factoring company’s profit is determined by the buy/sell differential, the quicker it can collect from the debtors the better the margin and therefore the collection tactics used with debtors may be aggressive.
Factoring is also far less flexible than conventional financing as it involves outsourcing all credit control processes to the factor and relinquishing control of day-to-day operations. For many business owners this is something they feel uncomfortable doing.
It’s generally used by businesses that need cash quickly and are willing to sell their invoices in exchange for an immediate payment. Factoring may be used by businesses that are in distress and are selling assets including their invoices to bring in cash.
What is invoice financing?
Invoice financing also uses unpaid invoices to access cash quickly, however the business retains control over their debtors’ ledger and also management of their debtors. With invoice financing, the financier establishes a facility which provides a revolving line of credit secured by the accounts receivables ledger of the business.
The business can draw as much or as little of the availability each day that it requires to manage their daily cash flow needs. It’s like a business overdraft except better, as availability is determined by the value of the business’s sales, so the facility limit can increase in line with increasing revenue. Unlike a traditional business loan that requires the business to service the loan by making regular repayments, with invoice finance, the financier gets paid back when the debtor pays the invoices.
Invoice financing is typically most beneficial for businesses that are in the growth phase of their life cycle and need working capital to drive that growth. When a business is going through a rapid growth phase it needs cash to take on new contracts, new employees, upscale machinery or premises. So it’s spending money before it makes any – and invoice financing can bridge that gap. It allows financial controllers to be very accurate with their cash flow and budgeting because if they have invoice financing, they know when they hit their forecast sales they can get up to 90 per cent of that in cash immediately, allowing them to plan for expenditure, input and purchasing for future sales.
Invoice financing is popular across a range of industries including manufacturing, wholesale trade, transport and logistics, labour hire and many others, as it can help ease supply chain constraints and ensure products continue to flow through to customers.
Used for the right circumstances, both factoring and invoice financing can help businesses access cash quickly by using their outstanding invoices as collateral. But it’s important to evaluate the costs and benefits of each option before making a decision that suits your business needs. Maintaining cash flow is essential for the financial health of every business so it makes sense to consider your options carefully.
Angus Sedgwick is CEO of OptiPay.
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