Invoice Financing vs. Invoice Factoring

Lauren WardUpdated May 8, 2023

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If you have a small business that invoices customers (and then waits 30 days or longer for payment), you know that cash flow can be a big concern. You may also have heard about two financing options that can help you get your invoices paid faster: invoice financing and invoice factoring. While both funding options allow you to use your company invoices to secure a cash advance, they work in very different ways. Here’s what you need to know about invoice financing vs. invoice factoring.

What Is Invoice Financing?

Invoice financing helps bridge short-term cash flow issues that might occur because of unpaid invoices from clients. You can use those invoices as collateral in order to receive a lump sum of financing before they’re paid. Usually, you’ll receive between 80% and 90% of the invoice total face value upfront. Then, once the invoice is paid, you’ll receive the remaining balance, minus the company’s fees. The fees are often a percentage of the invoice amount, typically between 1% and 5%. The rate can be charged as a one-time fee, or on a weekly or monthly basis, depending on the lender and terms determined.Invoice financing is also known as accounts receivable financing because the borrowed funds are secured by future revenue. It’s considered a type of cash flow loan. One of the benefits of invoice financing is that you maintain direct relationships with your customers, rather than having the financing company manage the collections process on your behalf, which is typical with invoice factoring.

Example of Invoice Financing

Here’s an example of how invoice financing works. Say a company decides to finance $10,000 in invoices. It received 80% upfront, thus adding $8,000 back into the business’s cash flow. The invoice financing company charges 3% for every month the invoice is outstanding. After two months, the customer pays the bill. The company is charged 3% monthly, which amounts to $300 per month.So, instead of receiving the remaining $2,000, the company receives $1,400. The total cost of the invoice financing was $600 in this hypothetical situation.

Pros and Cons of Invoice Financing

There are both benefits and drawbacks to using invoice financing.

Pros

Keeps you in control With this type of financing, your company is still in charge of the collection process. That means you get to maintain your relationship with your customers and they don’t have any insights into your business’s finances.
Smoother cash flow For companies that largely deal with other businesses, invoice financing can help alleviate cash flow issues due to unpaid invoices.
Relatively easy to get Since your invoices serve as collateral for the cash advance, invoice financing can be easier to qualify for than other small business loans. Lenders are usually more concerned about your customer’s payment history than your (or your company’s) credit history. This means you may be able to qualify even if you have a limited or bad credit.

Cons

Can be costly While a fee of 1% to 5% may sound low, you need to keep in mind that this rate is often charged on the total invoice value per month and, in some cases, per week. Invoice financing companies may also charge fees, such as maintenance fees, invoice processing or advance fees, and early termination fees.
Uncertain costs Although you retain control of collecting payments, you’re not in control of the total cost of invoice financing. Your business could end up paying a lot if a customer takes months to pay.
Liability for unpaid invoices Your business may be responsible for repaying the borrowed funds in full if customers don’t pay their invoices.

What Is Invoice Factoring?

Invoice factoring is similar to invoice financing, but with a few key differences. With invoice factoring, you don’t use your invoices as collateral for a loan but, rather, sell your outstanding invoices to a factoring company at a discount. The company pays you a percentage of the invoice amount upfront and then takes on the responsibility of collecting the full amount from your customers. Once they receive full payment, they send you the remaining percentage, minus their fees.Recommended: What Is Purchase Order (PO) Financing?

Example of Invoice Factoring

There are a number of ways an invoice factoring agreement could be structured. But here’s an example of a company that uses invoice factoring at a rate that amounts to 1% for every 10 days it takes the customer to pay a $10,000 invoice.The business receives 80% ($8,000) upfront, and the factoring company takes over the collection process.The customer takes eight weeks to pay the invoice, resulting in an 8% fee — or $800. The remaining $2,000 balance is reduced to $1,200 to cover the fees. So the company receives a total of $9,200 for the customer’s $10,000 invoice.

Pros and Cons of Invoice Factoring

Invoice factoring can help ease cash flow issues, but there are also drawbacks to consider.

Pros

Doesn’t require collateral Invoice factoring is considered unsecured financing. You usually sell the invoices to the factoring company, but you don’t need to worry about using other company assets to secure the loan.
Smoother cash flow This type of financing can improve your company’s cash flow.
Available with bad credit You could get approved even with bad credit.

Cons

Could jeopardize customer relationships You can’t control how the factoring company deals with your customers when it’s collecting invoices. Also, your customers will know you're having issues with cash flow.
Can be expensive Compared to other types of small business loans, invoice factoring often costs more and is accompanied by additional fees.
Liability for unpaid invoices Depending on the factoring is structured, you may be responsible for the borrowed funds if your customers don’t pay their invoices.

Invoice Financing vs. Factoring: What’s Right for You?

Which type of financing will work best for your small business will depend on the details of the agreement and your relationship with your customers.If you’re a new business and don’t have the time or staff to follow up on customer invoices, you might prefer invoice factoring. If, on the other hand, you have personal relationships with your customers, want to remain in control of the payment collection process, and feel confident you can collect on your outstanding invoices quickly, then invoice financing might be the better way to go.With either arrangement, you’ll want to pay close attention to costs and read the fine print about rates and fees, as well as your liability if your customers don’t pay their invoices. Recommended: Purchase Order Financing vs Factoring

The Takeaway

If you invoice customers, either invoice financing and invoice factoring can help you manage cash flow issues or cover short-term expenses while you’re waiting to get paid. With both types of financing, you use your unpaid invoices to access capital for your business. With invoice financing, your invoices serve as collateral for a cash advance. With invoice factoring, you sell your invoices at a discount to a factoring company that then collects payment for you.If you're interested in exploring your small business financing options (including invoice financing, business lines of credit, and term loans), Lantern by SoFi can help. You can use our fast online search tool to get a personalized small business loan option in minutes.Let Lantern help you find the right financing solution for your small business.

Frequently Asked Questions

What is the difference between invoice financing and factoring?

What are the pros and cons of each?

Photo credit: iStock/RichVintage

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About the Author

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.

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