Invoice factoring and invoice discounting are two types of invoice finance products that allow businesses to access funds from their unpaid invoices. Invoice finance is a form of asset-based lending that can improve cash flow, reduce credit risk, and support business growth. However, there are some key differences between invoice financing and invoice discounting in terms of how they work, who they are suitable for, and what benefits and drawbacks they have.
Invoice Factoring
Invoice factoring is also known as accounts receivable financing. It involves selling the invoices to a third-party provider (a factor) at a discount. The factor pays the business a percentage of the invoice value (usually 80-90%) upfront and takes over the responsibility of collecting the payment from the customer. The factor then pays the remaining balance (minus fees and interest) to the business once the customer pays. Invoice financing is considered a true sale of receivables, meaning that the business transfers the ownership and risk of the invoices to the factor. Invoice financing is usually disclosed to the customers, who pay directly to the factor.
Invoice factoring can be with recourse or without recourse to legal means to reclaim the money from the seller if there is a default in payment from the debtor.
Invoice Discounting
Invoice discounting is a form of short-term borrowing that uses the invoices as collateral. The business retains the ownership and control of the invoices and continues to collect the payments from the customers. The lender pays the business a percentage of the invoice value (usually 80-90%) upfront and charges interest and fees on the amount advanced. The business then repays the lender once the customer pays. Invoice discounting is not considered a true sale of receivables, meaning that the business remains liable for any bad debts or defaults. Invoice discounting is usually confidential, meaning that the customers are not aware of the arrangement.
Pros and Cons
Both invoice Invoice factoring and invoice discounting can provide immediate cash flow to businesses that have long payment terms or slow-paying customers. However, they also have some advantages and disadvantages depending on the business’s needs and preferences. Some of these are:
- Invoice factoring can provide more cash flow than invoice discounting, as it releases up to 100% of the invoice value, while invoice discounting typically releases up to 90%.
- Invoice factoring can reduce the administrative burden and cost of managing the sales ledger and chasing payments, as these tasks are handled by the factor. Invoice discounting requires the business to maintain its own credit control and collection processes.
- Invoice factoring can improve the credit rating and reputation of the business, as it reduces its debt-to-equity ratio and shows that it has a reliable source of funding. Invoice discounting can increase the debt level and risk exposure of the business, as it adds to its liabilities and interest expenses.
- Invoice factoring can be more expensive than invoice discounting, as it involves higher fees and charges for the factor’s services. Invoice discounting can be cheaper than invoice financing, as it involves lower interest rates and fees for borrowing.
- Invoice factoring can be more flexible than invoice discounting, as it can accommodate seasonal or fluctuating sales volumes and customer profiles. Invoice discounting can be more restrictive than invoice factoring, as it may have stricter eligibility criteria and covenants.
Differences in the UK and the EU Regarding Invoice Finance and Invoice Discounting
According to the World Finance Year Book 2022, invoice discounting business worth £239 billion was conducted in the UK in 2021. Compare that to only £18 billion in invoice factoring business. These figures derive from the client turnover for UK Finance’s Invoice Finance and Asset-base Lending Members (IF/ABL).
In contrast, figures from the same source for 2021 shows the domestic invoice factoring market in France raised €236 billion, whereas domestic invoice discounting was only worth €27 billion. France is typical of the EU in general in preferring invoice factoring to invoice discounting.
Cross Border Financing
There is no definitive data on how much cross border financing is funded by French factors compared to UK factors, but some estimates suggest that France accounts for about 20% of cross border factoring volume in Europe, while UK accounts for about 10%. This implies that French factors are more active in providing cross border financing than UK factors, especially in markets such as Africa, Asia, and the Middle East.
Why the Different Approaches?
One possible reason why UK factors prefer the invoice discounting model over the invoice factoring model is that it allows them to retain more control and discretion over their lending decisions and risk management. Invoice discounting gives the lenders more flexibility to choose which invoices to fund, how much to advance, and what terms and conditions to apply. It also reduces the operational costs and complexity of collecting payments from customers in different jurisdictions and currencies. Invoice factoring, on the other hand, requires the factors to take over the full responsibility and risk of the invoices, which may expose them to higher default rates, fraud, and regulatory compliance issues.
Another possible reason why UK factors prefer the invoice discounting model over the invoice factoring model is that it reflects the preferences and expectations of their customers. UK businesses may value the confidentiality and autonomy that invoice discounting offers, as it allows them to maintain their customer relationships and reputation. They may also have more established and efficient credit control and collection systems that make invoice discounting more feasible and cost-effective. Invoice factoring, on the other hand, may be perceived as a sign of financial distress or weakness by some customers, who may prefer to deal with their original suppliers rather than third-party factors.
On the contrary, one possible reason why EU factors prefer the invoice factoring model over the invoice discounting model is that it enables them to provide more value-added services and solutions to their customers. Invoice factoring allows the factors to offer more comprehensive and tailored support to their customers, such as credit insurance, cash management, trade finance, and advisory services. It also allows them to leverage their expertise and network in different markets and sectors, which may give them a competitive edge over traditional bank lenders. Invoice discounting, on the other hand, may limit the factors’ involvement and interaction with their customers, as it reduces their role to a mere financier rather than a partner.
Another explanation why EU factors prefer the invoice factoring model over the invoice discounting model is that it reflects the regulatory and legal environment in which they operate. EU countries may have more harmonized and favourable rules and standards for invoice factoring than for invoice discounting, such as the EU Directive on late payment, which gives factors more protection and incentives to collect payments from customers. They may also have more developed and integrated markets for invoice factoring than for invoice discounting, such as the Factors Chain International, which facilitates cross border cooperation and transactions among factors. Invoice discounting, on the other hand, may face more barriers and challenges in terms of regulation, taxation, accounting, and enforcement across different jurisdictions.
In Summary
These are some tentative explanations for why UK factors prefer the invoice discounting model while EU factors prefer the invoice factoring model. However, there may be other factors that influence their choices, such as market demand, customer behaviour, competitive pressure, technological innovation, and cultural differences. Therefore, further research and analysis are needed to verify these hypotheses and explore other possible reasons.
