Another means of internal funding is invoice discounting, which is similar to debt factoring in many ways except for one important difference. In this case, the third party (an invoice discounter) will carry out a mini audit of the business and its customers upon the receipt of a copy of an invoice. The invoice discounter will then provide an agreed percentage of an invoice’s total value. As soon as the customer pays the invoice, the business will deposit the funds into a bank account that is controlled by the invoice discounter, who will then pay the business the remainder of the invoice, less any fees.
Unlike debt factoring, with invoice discounting it is the business itself that deals with the process of requesting the money from its customers. Whilst this would be a viable option if the business is equipped with a dedicated office (e.g. a debt collection department), it could be more problematic for newly established businesses.
In comparison to debt factoring, an obvious advantage is that the seller and the customer are in a clearer, more direct relationship. In addition, given the simpler service provided by the discounting company, invoice discounting usually has lower fees (usually around 0.5% to 1% of the sale value).
Both debt factoring and invoice discounting are ways of raising finance that can be very flexible. However, these two types of financing come with some disadvantages.
Activity 2 Disadvantages of debt factoring and invoice discounting
Think about potential drawbacks connected to debt factoring and invoice discounting and note your ideas in the box below. How do your ideas compare to the feedback?
In both debt factoring and invoice discounting, if customers do not honour their debts, then the business will have to pay off the funds that the factoring or discounting company has advanced in addition to the fees. Moreover, in the specific case of factoring, since the business cannot control the way in which the factoring company deals with the customer, there can be some degree of reputational risk (e.g. customers might not like the way in which the factoring company collects payments).