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What is the Difference Between Factoring and Invoice Discounting?
Factoring and invoice discounting are two techniques a company uses to improve its cash flow. When factoring invoices, companies sell unpaid invoices or open accounts receivables to a third party and receive cash for the invoice. Invoice discounting occurs prior to the factoring process. Suppliers and vendors offer invoice discounts to customers in order to receive payments on an invoice sooner rather than later. For example, offering terms like 1/10 Net 30 means customers will receive a 1 percent discount if they pay the invoice within 10 days, with the full balance due in 30 days.
Having a strategy for factoring and invoice discounting is often necessary. The latter business technique is quite common; business owners and managers should review the current terms offered by other companies in the industry. Offering terms that are too favorable when compared to competitors can result in losing profits and the inability to pay bills to remain in business. In this scenario, the company will make smaller profits over time but it cannot expand and increase expenditures without using credit to offset the short-term cash shortages.
Companies do not need to offer all customers the same discounts when factoring and invoice discounting. Consistent customers who offer stable business may receive higher discounts. This builds loyalty with the customers and can help earn more business. Using invoice discounting can also reduce the need for factoring invoices to third parties. Although these techniques can reduce the amount of cash received by a company, factoring typically results in less cash received when compared to invoice discounting.
Factoring invoices result in selling the rights to collect the funds to another company. Many businesses will sell invoices or open accounts receivable accounts that are older than 60 days in terms of accounting dates. Most factoring companies will offer cash value at 70 to 90 percent of the invoice’s face value. Businesses will retain this cash and be able to use it for paying bills or expanding the company. Factoring companies will often pay an additional 25 to 50 percent once they collect the entire balance owed on the invoice. The portion not paid by the factoring company is the price paid for the factoring service.
Not all companies can or should use factoring and invoice discounting procedures. Companies that can quickly collect their outstanding invoice balances will lose money on these activities. Additionally, selling invoices to factoring companies that result in uncollectable accounts can reduce the company’s reputation in the business environment. Factoring companies may also offer poor terms for invoice factoring, resulting in higher costs for the business.
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Discussion Comments
That's where the bad reputation of factoring comes in -- from those almost uncollectable debts handled by companies that don't care much about the Fair Debt Collection Practices Act and hope the people they're trying to collect from don't, either. When you hear people complain about aggressive collectors, they are often talking about those companies that make a living using whatever tactics they think they can get away with to collect old debts.
In truth, the valuable debts that are sold in factoring will contain complete information and are handled by companies that do follow the limits of the law when they are trying to get debts paid. In other words, a few bad apples really have cast a negative light on an entire industry.
Factoring is quite controversial because the company that purchases the invoices may or may not have all the necessary information to collect the debt. For example, the Fair Debt Collection Practices Act states that every debtor has the right to request a verification of a debt from a creditor and that must be sent. The original bill in which the debtor incurred the debt, for example.
It is quite common for a company to not include such details when selling a debt to another business for collections. If the debtor asks for a verification and it is not provided, then the bill collector is prohibited from contacting the debtor again.
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