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The Basics of Invoice Financing and Invoice Factoring

The Basics of Invoice Financing & Invoice Factoring

Invoice financing and factoring are the two types of accounts receivable financing. In the following lines, we will learn the basics of Invoice financing and factoring.  

Accounts Receivable Financing 

Account receivable financing is where a business gets financing (borrows) the amount against a ratio of its outstanding receivables. Accounts receivable are the invoices with some future payment date. The purpose of this financing is usually to improve cash flows. As a business, no matter how big or small, it needs a sustainable cash flow. Businesses with a large volume of non-cash sales always find themselves in a cash crunch. To make their cash flow better, they use accounts receivable as collateral. The most common form of the account receivable that can be used as collateral is an invoice. That is why accounts receivable financing is commonly known as invoice financing or invoice factoring.  

Invoice financing and invoice factoring, are both financing solutions that work around receivable invoices. The mechanism is almost the same in both cases with a little difference. Let’s take a look at both to understand the basics and the difference between them.  

How Accounts Receivable Financing Works 

To understand how accounts receivable finance works, let’s look at a scenario.  

A business ‘A’ sells goods to business ‘B’. The terms of the deal are immediate delivery of the goods from A to B and the payback from B to A to be done after 90 days. A goes to the financing institution ‘C’ and asks for financing against its receivable invoice. C finds it viable and agrees to that and pays a percentage of the total invoice due to A. After 90 days B pays back the outstanding amount of the invoice to A and A pays back its dues to the lender along with agreed-upon service charges and/or markup.  

Difference between Invoice Financing and Invoice Factoring  

Invoice financing and factoring are slightly different in terms of mechanism. Let’s see how, considerning the above scenario 

Invoice Financing  

In invoice financing, the seller gets the upfront financing against the invoices and retains ownership of the invoices.  At the due date, collects the payment from the buyer and pays the financed amount back to the lending institution along with the service charges/markup.  

Invoice Factoring 

In invoice factoring, the seller gets upfront financing at a certain ratio and handovers the invoices to the lending institution. At the due date, the financing institution directly gets the payment from the buyer.  

For a general understanding, the difference between invoice financing and factoring is the handing over of collateral and collection responsibility. In invoice financing, the seller retains the invoices and is responsible for collection and payback to the lender. In invoice factoring, the lender takes the invoices from the seller and collects the payment directly from the buyer.  

Pros and Cons of Invoice Factoring 

Invoice factoring is beneficial for sellers as they get upfront payment, and all the responsibility of collection is transferred to the lender. The seller has nothing to do with the receivable collections afterward. 

At the same time, factoring has certain issues that can affect business. For factoring the buyer must be aware of the fact that his payables have been transferred to a 3rd party (the lender). This can be unacceptable for many businesses as their buyers may have privacy issues. They may not want to disclose their transactions to a 3rd party or may not want to deal with a 3rd party at all. For a business itself, it can be problematic as it may be translated as the weaker financial health of the business by the buyers.  

Pros and Cons of Invoice Financing 

Unlike invoice factoring, you can fulfill your cash flow needs without getting your financial affairs exposed to the buyer with invoice financing. It also doesn’t require you to involve a 3rd party in your transaction with the buyer.  

In invoice financing, the collection of receivables remains with the seller. The seller is the sole responsible for collection and repayment to the financing institution. So, in case of non-payment or default by the buyer, the seller has to repay or reschedule the payments with the bank/financing institution which could be hectic. 

Challenges of Invoice Financing/Factoring 

Be it invoice factoring or invoice financing, the purpose of both is to improve cash flow for the business. 

Invoice financing / factoring is different from other business financing due to the two characteristics that are: 

  • It is a short-term financing, usually the financing period remains within months and not years.  
  • There is no separate collateral, the receivable invoice itself acts as collateral. 

Due to the above two reasons, invoice financing has never been able to become a preferred financing medium for financing institutions. Though invoice financing is a very viable financing solution for businesses but financing institutions are reluctant to work on these types of financing. The reason is very straight. As stated earlier, in the invoice financing/factoring, it’s the invoice that act as collateral. In most types of business financing, capital assets act as collateral. It can either be a fixed asset like land, building, or plant & machinery or it can be a trustable security like bonds, shares or certificates. As invoice is an internal document of transaction two parties, so it is very difficult for a 3rd party i.e., a financing institution to validate the integrity of an invoice. An invoice can be subject to multiple type of frauds and issues. Some of those are: 

  • Fake / Thin Air Invoicing 
  • Duplication 
  • Error and Omission 
  • Hidden disputes 
  • Tampering/forging 
  • Collusion  
  • Re-Ageing 

Due to the above fraud and discrepancies, to validate an invoice as a genuine collateral, the financing institution needs a thorough compliance (due diligence). This compliance is a tedious process that requires time and money. For a financing of few months span, financial institutions find it inviable to invest time and money at this scale. That is why the invoice financing is the least adopted type of business financing constituting only 0.051% share of the total financing market.  

The Solution 

The only way invoice financing can be viable for financing institutions is to ensure the integrity of receivable invoices through a cost-effective and speedy compliance. That’s exactly what InvoiceMate offers. InvoiceMate is the only blockchain-powered invoice management system in the world. InvoiceMate covers the whole journey of invoice from procurement to payment on a distributed, decentralized, immutable ledger of blockchain.  

Know Your Invoice (KYI) 

KYI is a service offered by InvoiceMate to financing institutions. Just like the familiar KYC service, KYI is a third-party compliance service that ensures the integrity of invoice through the inherent trust and transparency features of blockchain. Through KYI, lending institutions can get real-time validation of the integrity of an invoice in a cost-effective manner. This helps them overcome the compliance issues that bar invoice financing.  

More about KYI can be found here 

To learn more about InvoiceMate visit: Invoicemate.net