Factoring and Invoice Discounting – What Are the Differences?

Whether you are a new business dependent upon regular cash flow, or anticipate an increase in sales and are eager to take advantage of it, then perhaps you should consider a factoring facility. There are many benefits to factoring and invoice discounting, and they could prove to be the answer to your cash flow problems.

If you are already familiar with factoring then you will have also heard of invoice discounting. The invoice finance market consists of factoring and invoice discounting companies; these can be operated by well-known big banks or independently run specialised companies. Each one sets their own criteria, capabilities and prices which can vary greatly.

Factoring and discounting are both quite similar, but you need to have an understanding of both before you can make a decision about which would suit your business needs the best. Here is a quick explanation and their main advantages.

Invoice Factoring – Factoring is a finance facility that enables you to raise finance based on the value of your outstanding invoices. Instead of sending out invoices and then waiting up to a month or more for the cash to arrive, you can change them into cash almost instantly. Many businesses just starting out have come to the realisation that factoring offers a more flexible source of working capital than overdrafts or loans.

Factoring an invoice basically means that your company is selling the financial rights of the invoice to the factoring company. The transaction is arranged as a sale and the factoring company will pay you the invoice amount in two payments. The first payment is known as the advance and given to your company as soon as you sell the invoice to them; this can be up to 90% of the invoice. The remaining 10% to 20%, the rebate, is received when the client actually settles the invoice.

When applying for a business loan you generally have to wait some time before finding out if the application was successful or not. Factoring is much easier and quicker as the waiting period is much shorter. As the factoring companies generally buy the invoices from the company, their main worry is if the company paying the invoices has good credit, this means that small businesses or those needing to raise cash have a much better chance of getting a factoring line, as long as they work with a strong client list.

There are various fees attached to invoice factoring services, they can be higher than the cost of a business loan and are decided according to the size of the line, the credit quality of the invoices, and how stable the client’s business is.

Invoice discounting – This works in the same way that factoring does, by freeing up cash from your invoices. The difference is that the lender does not offer credit management services to facilitate collecting your outstanding invoices. The service will just release up the invoice value, which can be up to 90%, and you keep control of the credit management. The remaining 10% is then accessible when your customers pay the invoice.

Cash is the livelihood of every company and if you are owed it but don’t not actually have it in your hand then this can cause you a lot of frustration and potential headaches. Invoice discounting lets you keep control of your debtor book as you are in charge of managing the credit, this means that your business is responsible for collecting clients outstanding due payments.

The advantages of using invoice discounting are that it has no affect on the relationship between you and your clients. There is no reason for them to know about the contract, particularly if you operate a confidential invoice discounting facility. This ensures you are able to carry on providing the same credit terms arranged prior with your clients without affecting the company’s cash flow.

Your business retains control of the company’s sales ledger and manages the credit control. By releasing up to 90% of the gross invoice value it provides your business with the answer to cash flow problems. Usually invoice discounting is cheaper than factoring as it doesn’t take up as much time, however, it does have a higher risk potential.

A quality factoring company will provide you cash against your existing debtor book and finance invoices as you raise them. They can also assist by collecting the outstanding payments by way of their credit management service.

Why Using Invoice Factoring Is a Smart Business Move

Many businesses struggle with having enough money on hand to meet financial obligations. This is the definition of a “Cash Flow” problem. To address this problem, companies generally take one of two approaches:

 

  1. Use other people’s money (OPM), i.e., borrow; or
  2. “Bootstrap” the business by using its own assets and financial resources.

 

Most business owners instinctively look to borrowing as the solution. This article discusses Bootstrapping as a viable alternative.

Other People’s Money

Using OPM involves either equity financing (selling away a piece of the business – and thus part of your autonomy) or debt financing (borrowing). This article focuses on debt financing.

“Debt” is the money owed to another person or institution. If used to address a Cash Flow problem it can be an albatross around the neck of a company. When a business “borrows” money (i.e., takes out a loan), it incurs a debt that must be repaid. The repayment includes both principle (the amount borrowed) and interest (the fee to be paid to the party that lent the money).

Debt puts a constant demand on cash flow. That’s because you are obligated to pay back the loan through monthly installments. Whether your business is having a good month or a not so good month you must direct funds to the lender or face the possibility of default. If you default, the lender has the right to foreclose and take whatever assets are necessary to pay the debt in full.

OPM’s Impact on the Balance Sheet

The act of borrowing forces a double entry on a company’s Balance Sheet. The cash acquired by virtue of the loan becomes a “Cash” Asset on the books. However, an offsetting Liability must also appear because that money is not yours and must be paid back.

This is an important distinction because one of the ratios used in assessing the financial health of a company is the Debt to Equity Ratio. This ratio is calculated by first taking the value of a company’s Assets and subtracting its Liabilities. The remainder is the company’s Equity. The Liability value is then divided by the Equity value to determine the ratio. The higher the ratio number the greater the risk that the company will not be able to meet its loan payment obligations.

This ratio can impact the ability to borrow more money. It can also impact the willingness of vendors to extend payment terms to your business. A highly leveraged company can be a poor credit risk which can cause vendors to demand cash payment for merchandise.

Bootstrapping the Company

Bootstrapping does not have the downside potential of borrowing. When bootstrapping you use the existing resources of the company to leverage growth. This leverage involves understanding all the assets your company has and how to capitalize on them.

For companies with business-to-business (B2B) and/or business-to-government (B2Gvt) transactions one of the best assets to leverage is its Accounts Receivable. Accounts Receivable (A/R) is the volume of money owed to you for product delivered and/or service rendered. It is a debt that another company or government agency owes to you.

Unfortunately, you can’t spend A/R. That money is not in your bank and can’t be used to meet payroll, buy material or pay taxes. You can, however, convert that A/R to cash without pressuring your customers to alter their payment terms. The solution is to factor the invoices. “Invoice Factoring” is the process of selling individual outstanding invoices for cash. It is a transaction that stays exclusively on the Asset side of the ledger in that it converts A/R to Cash. In an invoice factoring transaction you are not borrowing money; you are selling an Asset. Therefore there is no Liability entry on your books.

Under What Circumstances Can Factoring Be Used?

The utilization of Invoice Factoring is a right granted to a business by virtue of Article 9 of the Uniform Commercial Code. A business may “assign” the right to payment to a third party – a factoring company. There are very, very few situations where your right to assignment may not apply. This means that any B2B or B2Gvt enterprise can use Invoice Factoring as a means of resolving a Cash Flow challenge.

Which Financial Institutions Offer Invoice Factoring?

While a few larger banks have departments that do true Invoice Factoring, most do not. One reason is that, in general, the underwriting criteria for Invoice Factoring differ from that of a traditional business loan. But because banks are regulated by the Federal Reserve, those that do have Invoice Factoring Departments will typically apply the same underwriting criteria to both lending and factoring. This means they will look very closely at the personal credit and business credit of those applying for a factoring facility. If those scores are not good, the application will be declined.

Independent financing companies have greater leeway. Their primary consideration is the creditworthiness of your customer – the entity obligated to honor your invoice. If their commercial credit rating is good, the probability of winning a factoring facility is very high. Your company’s credit and/or your personal credit score will have little impact on the decision to fund.

Summary

When confronted with a cash flow problem, the majority of business owners impulsively look to borrow money. This is a viable route, but it important to understand the potential challenges:

 

  • It adds a Liability to your Balance Sheet
  • It affects your credit rating
  • It raises your Debt to Equity Ratio
  • It imposes an additional monthly demand on cash flow
  • It automatically creates the possibility of default and foreclosure

 

Bootstrapping and the use of Invoice Factoring is a reasonable alternative. It offers a quick and effective way for a company to use its existing resources to solve a problem. It is inexpensive, and, by law, universally applicable. Used correctly, it can help a company survive in difficult times and thrive when times are good.

Tips About Invoice Factoring

One of the most difficult things about being in business is cash flow, but invoice factoring may provide the means necessary to keep the business flowing. After all, you need a certain amount of cash on hand at all times. But what if you have a stack of invoices that just haven’t brought in the cash yet? You can’t afford to wait until those customers decide to pay you. If you want to be successful, you’ve got to charge on-even if you don’t have cash on hand.

This may sound impossible, but there are solutions for businesses that have a cash flow problem. Invoice factoring is one of the easiest ways to keep the cash flowing even though your invoices remain unpaid. Here’s how it works. You receive quick cash based on that stack of invoices. It’s quick and easy. The invoice factoring company simply buys your invoices and gives you an advance payment to tie you over until your customers actually pay. Their payment then goes straight to the invoice factoring company. If it sounds too good to be true, then it helps to understand more about the process.

Here are some tips to help you use this financial vehicle successfully:

• Most invoice factoring is done in two installments. The first one is basically an advance, and it is given to you when you hand over the invoice to the financing company. The second payment, which is also known as the rebate, is given to you after your customer pays the invoice.

• Advance payments can be anywhere from 60 to 90 percent of the gross value of the invoices, with 80 percent being about average.

• With this form of creative financing, you get paid immediately rather than having to wait one to three months for your own customer to pay you.

• The cost of using this service depends on three components. The credit level of your customers is one component, and the amount of time it takes for your invoices to get paid is another. The third component is the monthly factored volume.

• Usually you will pay anywhere between 1.5 percent and 5 percent for each transaction you make.

• Businesses that are growing quickly can especially benefit from this form of financing because it enables them to get the cash flow they need quickly to keep up with the rapid pace of orders coming in.

• Invoice factoring is different than a bank loan because most banks will not give you a loan based on the stack of unpaid invoices you have. The focus is instead shifted to how much credit your customers have rather than how much credit your business has.

• It’s helpful to have insurance against fraud and / or requiring your customers to be audited. This will help reduce the risk of using this type of financial solution.

• When choosing a company to handle this part of your financial affairs, choose one that is knowledgeable about the laws regarding it.

How To Improve Your Business’ Cash Flow Forecast With Factoring

Cash flow forecasting is good business practice for any business.

The cash flow forecast is divided into periods of time and shows the flow of cash through a business, what it starts the month with, what it receives, what it pays out and the balance of cash left at the end of the month. Normally the period will be months but where cash is tight a business may forecast their cash flow on a weekly or even daily basis.

The key issues that factoring addresses is that businesses tend to sell on credit terms to each other. That means that if you raise an invoice today it will typically be on 30 days payment terms. That means that it will be 30 days from today’s date until that invoice is due for payment.

The reality is that the time taken to pay that invoice can be much longer, may be 60 or even 90 days. There may be 101 different reasons for this but as examples, in some cases the customer may only pay invoices at the end of each month which means that an invoice received mid-month may only be paid at the end of the following month. In addition, businesses often stretch out their payments to suppliers, beyond their payment terms, in order to fund their own businesses. Put simply, if they don’t pay your invoice they don’t have to borrow the money from their bank in order to pay your invoice!

Below is an example of how delayed payment of invoices can affect the cash flow forecast of a small business:

Month 1 Month 2 Month 3 Month 4
Invoices raised (£)
10000 10000 10000 10000

Invoices outstanding at beginning of month
0 10000 20000 30000

Invoices paid by debtors during month
0 0 0 10000

Invoices outstanding at end of month
10000 20000 30000 30000

You can see that the business does not receive any cash from invoices being paid by debtors until Month 4.

Despite the lack of payment of your invoices the product still has to be purchased and delivered to the customer. Even if you are able to get credit terms from your suppliers it is unlikely that they will be long enough to account for the extended time that customers may take to pay you. Similarly, all your business expenses and bills still fall due each month and you need cash to pay them despite not having been paid by your customers. This creates a cash flow gap – the gap between the time that you have to pay your expenses and bills and the time that you get payment from your customers for the goods or services that you provide.

The cash flow forecast below shows how the expenses of the business fall due from Month 1 onwards but because of the delays in being paid by debtors, the business has a negative cash position throughout the forecast that will need to be funded from somewhere:

Month 1 Month 2 Month 3 Month 4
Invoices raised (£)
10000 10000 10000 10000

Invoices outstanding at beginning of month
0 10000 20000 30000

Invoices paid by debtors during month
0 0 0 10000

Invoices outstanding at end of month
10000 20000 30000 30000

Cash on hand at beginning of month
0 -6000 -12000 -18000

Cash received during month
0 0 0 10000

Expenses paid during month
6000 6000 6000 6000

Cash on hand at end of month
-6000 -12000 -18000 -14000

One solution is factoring bridges that cash flow gap, as soon as you raise your invoices a copy goes to the factoring company who then provide you with 85% (sometimes more) of their value immediately. That 85% means that you have the bulk of the money immediately, certainly enough to pay your expenses and bills within a business that has even the most reasonable of profit margins.

This cash flow forecast shows the same business but you will see that from Month 1 they receive 85% of the value of the invoices that they raise immediately:
NB Factoring charges are not shown in these examples but should be added into your forecast
That 85% is then repaid to the factoring company when the customer finally gets around to paying and the remaining 15% then becomes available to you from that payment (less the charges that the factoring company makes).

The above cash flow forecast also shows the effect of that balance of funds being past onto the business, after the customers pay, in month 4.

So by using forms of invoice finance such as factoring a business that could not afford to fund its cash flow gap is able to adequately provide enough cash to pay its business expenses as soon as it starts trading.

Cash Flow Forecasting for Milestone Billing

Forecasting cash flow for a one invoice project is pretty easy to understand. Cash will hit your bank account when that invoice becomes due. But what about projects that have multiple billing milestones? How can you predict cash flow for multiple future billings over an extended period of time?

*What do you really want to know?*

Part of the confusion with predicting cash flow is understanding which tool to use for the job. QuickBooks does have a cash flow forecasting report which is useful for telling you what should happen for the invoices and bills that have been entered into the system. This type of forecast will easily show you when payments should arrive in your bank account (if everyone pays what they owe on time) and when payments will leave your bank account (if you have every payment entered as a bill and pay them on time). If you want to know what should happen, the QuickBooks report will work just fine. If you want to know what will happen based on real life conversations….keep reading.

To generate the QuickBooks type of cash flow forecasting for progress billing, you would need to enter your invoices at the beginning of the project. You would then set a reminder to actually send the invoice on the date of said invoice. This approach is dangerous. There’s a pretty big risk that the invoice won’t be sent or, if the scope changes, no on will remember those invoices were out there. In those cases, your cash flow forecasting is wrong and you’ll end up calling collections for invoices that were never sent and/or aren’t owed.

*Real life is messy.*

In addition to the risks involved with invoicing early, the forecasting report is limited to what SHOULD happen. We all know real life is messier and you want to know what WILL happen to your cash. Every day you are having conversations about late invoices or accepting payment arrangements. You know that your biggest client always pays at 60 days, even though the invoice is due in 30 days. The only way to get those adjustments into QuickBooks is to change what should happen to what will happen.Do we really want to change due dates in QuickBooks to match what you know will happen? Absolutely not! We want our accounting systems to reflect our contractual agreements. We need to accurately reflect how past due invoices actually are. How else will you have effective collections conversations?

*A better tool for the job.*

The cash flow forecast, on the other hand, needs to be an estimation of what really will happen. A relatively simple Microsoft Excel spreadsheet is usually the best tool for the job. This spreadsheet will track when you expect your revenue to hit the bank account and when your bills and payroll will leave the bank account. The first column (each column represents a time period, usually a week) in your spreadsheet will begin with your bank account balance, then add incoming cash, subtract outgoing cash, and finally total to what you expect to have left in the bank. That ending bank balance will be the beginning bank balance in the next column (time period)…wash, rinse, repeat.

For our progress invoicing question, as soon as the project agreement is signed, we can drop the cash receipts into the weeks we estimate they’ll be received. Of course, the project may change course causing the invoice dates and cash receipt expectations to change. When that happens, we’ll make those adjustments in our spreadsheet and immediately see the impact on our cash balance.

Keeping an updated cash flow forecast will enable you to make smart money decisions. If you see the ending balance is going negative, you know you need to make some adjustments to your plan. If you want to make a large purchase or extend longer payment terms to a client, you can make those adjustments in your forecast; you’ll know if you have enough cash to support it before you make the commitment.

Cash in the Barrel: Oilfield Service Companies Between a Rock and Hard Place When Seeking Financing

Many oilfield service companies have major cash flow problems, and it’s not their fault. Most of the big oil and gas companies pay their invoices in 30-90 days. Many oilfield service companies don’t have the cash reserves to wait for those payments; they have their own obligations to meet. Oilfield service companies have high cash demands and slow turnaround times, and business owners feel it where it hurts-their pocket books. This puts oilfield service companies between a rock and a hard place.

At first glance, it would seem that the company should open up a traditional line of credit so they can pump working capital into the business as needed. In principle, this is a great idea. Getting a traditional line of credit is very difficult for many oilfield service companies because most banks require substantial collateral, clean balance sheets, and long successful histories. In reality, few oilfield service companies meet those criteria. But, there is a solution. Invoice factoring.

Accounts receivable financing, or factoring has gotten a bad rap-and rightfully so. When this method of financing started becoming popular in the US, many factoring companies took advantage of growing businesses that were vulnerable and were charging sky-high rates and running off their customers with aggressive collection practices.

Today, invoice financing has a whole new face and is much more business friendly.

Invoice factoring allows business, such as oilfield service companies, to capture revenues that would have been locked up in slow payment of invoices. Factoring reduces the time it takes your business to get paid, so you can stay current on payroll and payables.

There are three main benefits of invoice factoring for oilfield service companies:

1. Predictable and reliable cash flow: The business’ cash flow improves immediately as invoices are created and sold.

2. Increased sales: Flexible credit terms give the business a competitive edge in its marketplace. Predictable cash flow allows more sales to large but slower paying customers.

3. Reduce debt and fund growth:The proceeds from the sale of invoices can be used to pay off debt, take cash discounts on purchases, acquire inventory, or capitalize on growth opportunities.

The way invoice factoring works is quite simple: the factored invoice proceeds are sent to the business in two installments. The first installment (usually 90% of the face value of the invoice) is sent to you within 24 hours after submitting the invoice to the factoring company. The second installment, also called the reserve, is remitted to you, less the factoring fee, when your customer pays the invoice.

Factoring companies don’t look at your business’ credit, but they look at the credit worthiness of your customers. Businesses that have tax liens, recent bankruptcies, or debtor-in-possession even qualify invoice financing.

Invoice factoring is the perfect tool for stability and growth in oilfield service companies. Factoring lines are designed to increase as your sales grow and self-liquidate as they cool off, which helps smooth the cash flow cycle through periods of price volatility.

9 Rules of Cash Flow

There is an old saying: “When you’re out of cash, you’re out of business.” However cash flow can be one of the most difficult challenges when running a small business. Knowing some basic rules of cash flow can help to free you from money worries. These ten basic rules will help you take control of your cash so you can enable your business to succeed.

  1. Cash Is King. It’s important to recognize that cash is what keeps your business alive. Manage it with great care, because it is the lifeblood of your business.
  2. Never Run Out of Cash. Make a commitment to do what it takes to maintain cash flow. If you don’t, you’re out of business.
  3. Know Your Cash Balance. Do you know what your cash balance is right now? You should. It’s absolutely critical that you always know your exact cash balance. Failure is inevitable if you are making business decisions based on incomplete or inaccurate information.
  4. Daily on a Daily Basis. In other words, do today’s work today. The key to knowing your cash balance is to have up-to-date information in your accounting system. Having the numbers you need, when you need them is critical.
  5. Invoice Immediately. You can’t have cash in the bank until you collect it. If there is a delay in sending out your invoices, there will be an equal delay in receiving cash. Invoice daily if you can.
  6. Never Manage From your Bank Account Balance. Your bank balance is never a true measure of your cash. The cash in your bank account and your real cash balance are two different things. Don’t make the mistake of confusing them. Attempting to mange cash flow from your bank account is a prescription for failure.
  7. Forecast Your Cash Flow. What is your cash balance going to be like in six months? Knowing this can tell you if you are managing your business or if your business is managing you. Predicting your cash balance into the future will give you critical information you need to successfully manage your cash flow today. Be proactive in your approach to cash management.
  8. Cash Flow Issues Don’t Just Happen. It is amazing how many small businesses fail because the owner didn’t recognize that they had a cash flow problem in time to do something about it. Just like any other problem, there are always signs well before cash flow issues appear. Reviewing your cash flow forecast on a regular basis will help you to prepare well in advance of having a real cash problem.
  9. Get Expert Advice. Not all business owners are comfortable with calculating projections or conducting a trend analysis. Many times they just don’t have the time. Bookkeepers, although capable, may not provide the insightful knowledge that a seasoned professional may. Wrong information can lead to wrong decisions. Have an expert (a CPA, or Financial Analyst) review your accounts to help you make the best decisions you can make for your business. It is well worth the investment.

Taking a focused and pragmatic approach to managing your cash will allow you to ultimately focus on what you want most… growing your business. That’s a recipe for success.

Top 4 Tips for Healthier Business Cash Flow

If there’s one thing that Entrepreneurs and SME owners understand, it’s that good cash flow finance is the lifeblood of any business. A healthy cash flow will help a business to thrive and develop, while poor or irregular cash flow can cause it to stagnate or even fail.

Despite this seemingly obvious fact, cash flow issues are frequently neglected until it’s too late to recover. So what can a business do to manage its cash flow effectively? Here are some top tips.

1. Collect receivables instantly

Check the financial health of a new customer before offering them credit. Don’t offer overly generous discounts, and charge a “late fee” to customers who don’t pay on time.

2. Manage your cash

Although you should encourage your customers to pay as early as possible, your own outgoings should be managed carefully. Many people believe in staying ahead of bills and paying them as early as possible, but that’s just poor cash management. Be aware of any late fees you may be in danger of accruing, and schedule your payments to keep your cash flow balanced, as opposed to trying to pay all of your expenses at once. Make sure your employee payday is at a time of the month when you’re least likely to find yourself slipping into the red.

3. Ensure sales continuity

If you offer a regular product or service, consider offering a contract whereby customers can pay upfront to receive it for a fixed period of time. You may be familiar with this technique as it is frequently used in magazine subscriptions. A reader can often subscribe for, say, 24 issues of a weekly magazine for the price of 18, so long as they pay in advance. It’s easy to adapt this structure to almost any kind of regular service or subscription-based product, and helps to promote customer loyalty.

4. Consider using an invoice finance provider.

Invoice Finance is a method of controlling your finance by getting a cash injection when you need it, without resorting to a bank loan. Invoice factoring is a form of cash flow finance that allows you to use your customer invoices as collateral in return for ready cash, in some cases up to as much as 90% of the value of your outstanding invoices. The invoice finance company will then chase up the client payments on your behalf, leaving you with the funds you need, when you need them, and time to focus on other important areas of running and developing your business. Once the invoices have been paid, the finance provider will release the remaining invoice return minus their fees.

When using invoice finance, it’s important to select a factoring company that is well reputable and well-regarded in the industry. Make sure you check out any company you approach thoroughly, and make sure they have the appropriate accreditation. They should also be able to increase your funding as your business grows and develops.