What Is Invoice Factoring and Invoice Discounting?

Consumer CollectionsThe term factoring refers to the process by which a company sells its accounts receivable to a third party at a discount; that third party is known as a factor. Unlike a bank loan, which focuses on the total assets of the borrower, factoring concentrates almost exclusively on the accounts receivable; consequently, funds are available with factoring, even if they would not be if the owner had chosen to take out a loan. The factor thus assumes the financial burden that will result from uncollectible accounts, unless he chooses not to accept that risk, in which case a court will usually consider the transaction to be a secured loan.

Many companies resort to invoice factoring as a way of obtaining much needed cash. They may have made new orders or entered into contracts for which their accounts receivable are not enough to meet their financial obligations. Other companies, however, factor their receivables simply because it is the historically proven method of making funds available for growth, or to gain greater control over their cash flows. No tax statements, business plans or any such complexities are required when factoring.

Invoice discounting is often confused with invoice factoring. However, the former is a form of borrowing in which the borrower's accounts receivable are put up as collateral. Only businesses with a very high annual turnover rate and a good track record may resort to invoice discounting. The way it works is, the discounter, after making a thorough examination of the company and its clients, agrees to advance a defined portion of any outstanding sales. Having received notification of the invoices, he then decides on what percentage rate the funds will be made available at and the client can withdraw those funds at any time.

Discounting is more flexible than factoring: Interest is paid only on funds that have actually been borrowed. Another advantage is that there is no need for customers to know that the company is borrowing against sales that have not yet been paid. However, it is more difficult to manage the cash flows from discounting because the discounter requires that the amount collected on each invoice be paid. It can be more expensive than getting a loan and because the business is now dependent on improvements in cash flows, it is very difficult to leave a discounting arrangement.

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