Invoice factoring or invoice discounting: what's the difference?

What's the difference between factoring and invoice discounting?

The main difference is who collects the money. A factoring company takes over your sales ledger, sends statements and chases your customers, while with invoice discounting your own team does all of that and the lender stays in the background.

Set-up for either typically takes 1–4 weeks, depending on how quickly the lender can review your ledger and complete its checks.

How do the costs of factoring and invoice discounting work?

Both products usually have two main charges: a service fee for running the facility and a discount charge on the money you've actually drawn. Extras are where two similar-looking quotes often split apart.

• Service fee. Charged as a percentage of the invoices you put through the facility (your turnover through it), or as a fixed monthly amount.
• Discount charge. Charged on the cash advanced, for the days it's outstanding, usually quoted as a margin over a base rate.
• Extras. These might include set-up fees, audit fees, charges for same-day payments, minimum monthly fees, bad debt protection premiums and exit fees.

Worked example (illustration only)

Say a business raises £100,000 of invoices in a month and the lender advances 85% (£85,000). The service fee would be worked out on the £100,000 of invoices. The discount charge would be worked out on the £85,000 drawn, for the number of days until customers pay, so if customers settle in 45 days rather than 60, that part of the cost falls by about a quarter. Any audit fee or minimum fee would sit on top, regardless of how much you drew. When customers pay, the lender takes back its advance and fees and releases the remaining balance to you.

So a quote with a low headline service fee can still cost more once a minimum monthly fee or audit charges are added.

Which suits your business?

Factoring tends to suit smaller or faster-growing businesses that don't have someone chasing invoices every week. Discounting tends to suit businesses with higher turnover, a spread of reliable customers and a finance team that already keeps the ledger tidy.

Lenders weigh up:

• Turnover. Discounting lenders want more, as they rely on your controls rather than their own.
• Number of debtors. A spread of customers is easier to fund than one or two large ones.
• In-house credit control. If nobody owns collections today, factoring gives you that function as part of the facility.
• Sector. Recruitment, manufacturing, wholesale and business services tend to suit both products, as they invoice other businesses for work already delivered.

Why factoring isn't the weaker option

A good factor's credit control team does the chasing consistently, which can shorten the number of days customers take to pay, and that alone lowers the discount charge and frees up cash.

The real cost is the customer relationship. Your customers will deal with the lender over payment, so ask how the factor's team speaks to debtors and handles disputes. If you have a few sensitive accounts, a selective facility (see below) may be a better answer than turning factoring down altogether.

What does invoice discounting ask of you?

Discounting gives you more control, and in return the lender needs more evidence that your controls work. Expect regular reporting, periodic audits and a facility that can be tightened if your debtor book starts to slip.

What a lender's audit checks

Before the facility starts, and then usually once or twice a year, the lender sends an auditor to review your debtor book. They'll typically check invoices against delivery notes or timesheets, confirm a sample of balances with customers (without breaking confidentiality), review credit notes and disputes, and test your credit control procedures.

Monthly reporting

You'll usually upload an aged debt report and reconcile your sales ledger with the lender's records each month. If debtor days drift, aged debts build up or reporting goes late, the lender can lower the advance, reduce the limit or move you to a disclosed facility.

What other versions are there?

Confidential or disclosed

Confidential discounting is the usual form, where customers pay into an account in your name that the lender controls. Disclosed discounting means you still collect, but customers are told the lender has an interest in the debt.

CHOCs

CHOCs (client handles own collections) sits between the two. The facility is disclosed, so customers pay the lender, but your team does the chasing.

Selective or spot invoice finance

Selective invoice finance lets you choose which invoices or customers to fund, and spot finance funds a single invoice. These usually cost more per invoice but often come with shorter commitments, which can help with one large contract or a seasonal peak.

Recourse, non-recourse and bad debt protection

With recourse, you carry the risk if a customer doesn't pay, and the lender can ask you to repay the advance. Non-recourse, or bad debt protection, covers you if an approved customer becomes insolvent, up to an agreed limit and for a fee. It doesn't cover invoices a customer disputes, so it's not protection against quality or delivery complaints.

What contract terms should you check before signing?

The contract matters as much as the price, because leaving a facility early can be expensive. Ask for these points in writing:

• Minimum term, often 12 months, and whether it rolls over automatically.
• Notice period, commonly 1–3 months, and when you must give it.
• Minimum fees, payable even if you put fewer invoices through than expected.
• Exit and termination fees, including any charge for leaving during the minimum term.
• Audit fees and how often audits happen.
• Security, which often includes a debenture over the business and may include a personal guarantee or warranty from directors.

If you're switching from factoring to discounting with a different lender, the new lender will usually settle the old facility, but you'll need to time your notice so you aren't paying both at once.

What won't lenders fund?

Lenders only advance against your eligible ledger, which is often smaller than your total debtor book. Typical exclusions include:

• Invoices aged beyond about 90–120 days from the invoice date.
• Disputed invoices and those with credit notes pending.
• Contra accounts, where you also buy from the customer.
• Invoices to connected or associated companies.
• Amounts above a concentration limit, where one customer makes up a large share of the ledger.

So a business with £200,000 of debtors might find only £150,000 is eligible (illustration only), and the advance is worked out on that lower figure.