As a small or medium-sized business owner in South Africa, you know how important it is to maintain a steady cash flow. You need cash to pay your suppliers, and your employees, and to invest in the growth of your business.
However, there are times when cash flow becomes tight, and you find yourself struggling to keep up with your financial obligations. Below we’ll be discussing the differences between invoice discounting and invoice factoring so you can decide what’s best for your business.
For businesses looking to access much-needed funds, invoice discounting and invoice factoring can be valuable resources. These two financial tools allow you to access the value of your outstanding invoices and turn them into cash, giving you the financial flexibility, you need to run your business smoothly.
However, choosing between invoice discounting and invoice factoring can be confusing. Both options have their pros and cons, and it's hard to determine which one is right for your business. That's why we've summarized the differences between these two financial tools below, to help you make an informed decision and choose the best option for your business.
Invoice discounting is a financing solution that enables businesses to sell their unpaid invoices to a third-party financier, known as a "factor," at a discount. This provides immediate access to cash, which can be used to cover operating expenses, invest in growth opportunities, or pay employees.
The advantage of invoice discounting is that businesses retain control over the invoicing and collections process, as the factor does not take over the responsibility for collecting payment from the debtor.
On the other hand, invoice factoring (or disclosed invoice discounting) involves selling unpaid invoices to a factor who then takes over responsibility for collecting payment from the debtor. The factor provides an upfront payment to the business, which can range from 70-90% of the invoice's value, and then collects the full payment from the debtor.
Once the debtor has paid, the factor pays the remaining balance to the business, minus a fee for their services. One significant advantage of invoice factoring is that it eliminates the need for the business to handle the invoicing and collections process, saving time and resources.
The decision to use invoice discounting or factoring depends on several factors, such as:
Invoice discounting is a good option for businesses that want to maintain control over the invoicing and collections process while still accessing immediate cash flow. The business retains control over its customer relationships, collections process, and invoicing, while the financier provides the business with funding based on their accounts receivable.
Invoice factoring, on the other hand, is a better option for businesses that have difficulty managing their invoicing and collections process or have customers with less stellar payment histories.
By outsourcing the collections process to the factor, the business can focus on other areas of its operations. Additionally, factoring can provide a more consistent cash flow, as the factor provides an upfront payment based on the value of the accounts receivable.
Learn more about some of the industries that can take advantage of invoice discounting here.
Factors look at several elements when assessing the quality of a debtor's book, such as diversified invoice books and good quality customers. Factors require businesses to have diversified invoice books, meaning they should have a variety of customers across different industries and geographical locations.
This ensures that the risk is spread across a range of customers, rather than being concentrated in one area.
If a business relies on only a few customers, then the risk of non-payment is much higher, as any default by those customers could have a significant impact on the business's cash flow. Factors also require businesses to have good quality customers, meaning customers with a proven track record of paying their bills on time.
By working with good quality customers, factors can reduce the risk of non-payment and improve the chances of receiving payment on outstanding invoices.
The first step in the factoring process is the submission of an invoice to the factor. The invoice must be valid and unpaid, with no disputes or adjustments. The factor will review the invoice to ensure that it meets their criteria for financing.
Once the invoice has been submitted, the factor will conduct due diligence on the invoice and if they are a new customer, their creditworthiness must be assessed. This involves reviewing the customer's payment history, financial statements, and credit rating. The factor will also verify the authenticity of the invoice with the customer.
If the customer is deemed creditworthy and the invoice meets the factor's criteria, the factor will approve the invoice for financing. The factor will then provide the business with an advance on the invoice, typically ranging from 70% to 90% of the invoice value. The remaining balance, minus the factor's fee, is paid once the invoice is paid by the customer.
Once the invoice has been approved for financing, the factor takes over the responsibility of collecting payment from the customer. They will send a notice of assignment to the customer, informing them that the invoice has been sold to the factor and that payment should be made to the factor directly.
Once the customer pays the invoice, the factor deducts their fee and any other charges from the remaining balance and remits the balance to the business. The amount of the factor's fee varies depending on the size of the invoice, the creditworthiness of the customer, and the length of time it takes for the invoice to be paid.
Invoice discounting and invoice factoring are both viable financial tools for businesses looking to improve their cash flow. Businesses must weigh the pros and cons of each option and choose the one that best suits their needs.
Ultimately, with proper due diligence and careful consideration, businesses can use invoice discounting or factoring to unlock the value of their outstanding invoices and grow their operations. To learn about invoice discounting options offered by Geddes Capital, contact us here.