Factoring Vs. Discounting: 4 Key Difference You Should Know

For businesses that deal with credit, accounts receivable, and accounts payable are a crucial part of their operations. Therefore, they must manage both receivable and payable balances. That is mainly because managing these balances can significantly determine the relationship between the suppliers or customers and the business.

While accounts payable is in the control of a business, as it can decide when and how to pay these balances, accounts receivable is not. Accounts receivable balances depend on the customers. If all customers pay the business on time, there would be no need for it to manage the balance. However, that is only possible in an ideal business environment.

Due to the above reason, businesses have dedicated account receivable or credit control departments. The responsibility of a credit control department is to manage the accounts receivable balances of a business and ensure timely recoverability. By recovering accounts receivable balances, the credit-control department can also minimize the risks associated with bad debts.

The department achieves this by controlling the credit terms offered to a specific customer before a business makes sales to customers. Subsequently, the credit-control department can also accomplish that by following up with customers and ensuring they pay on time.

In some cases, the department may also offer customers early settlement discounts to encourage timely payments.

In some particular cases, where a business cannot afford to run a dedicated internal control department or cannot run it effectively and efficiently, it may have to look into other options to recover balances.

Similarly, some businesses may be short on cash and try to speed up the recoverability of account receivable balances. In these cases, they may have to use other options.

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The two main options businesses have when it comes to better and quicker recoverability of accounts receivable balances are factoring and discounting. While the purpose of both of them is the same, they are different from each other in some aspects.

Factoring Vs Discounting

Factoring

Factoring is the process of selling the accounts receivable balances of a business to a third-party, known as a factor. It allows businesses to receive short-term finance to fund operations. In factoring, a business sells all its invoices to a factor and receives cash in exchange for the invoices sold.

Usually, the business less compensation as compared to the value of invoices. It is because the factor also wants to make a profit through the recovery of those invoices. Usually, the factor pays 60 to 80 percent of the value of invoices to the business.

Factoring is a great way for businesses to offload the responsibility of a credit control department to a third-party. It is also a way in which they can outsource the credit control department.

Although the factor will pay the business lower as compared to if the business received cash for the invoices, factoring can save valuable time and reduce the chances of bad debts. However, the business still has responsibility for any invoices that the factor cannot recover.

Discounting

Discounting is a different process as compared to factoring. It is still a way for businesses to receive short-term cash from their invoices. However, in discounting, the business does not sell its invoices. Instead, it retains control over its invoices and recovery process.

Instead of selling invoices, it uses selected invoices against which it can borrow funds. Therefore, invoices act as security in discounting. Once customers clear the invoices, the business repays the entity that it received funds from

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, usually a financial institution.

In discounting, the control over the recoverability of invoices remains with the business, as opposed to in factoring. It can be helpful for different reasons but still means the business has to use resources towards recovering invoices.

Similarly, as with factoring, the business does not receive a loan against the full value of the selected invoices. It may receive up to 80% of the value of the invoices.

4 Differences

The differences between factoring and discounting are many. However, some of the main differences are listed below.

1) Control

As mentioned above, the main difference between factoring and discounting is the control of invoices. With factoring, the factor receives full control of the invoices. It means the business does not have any control over the invoices once the factor buys them.

On the other hand, with discounting, it still has control over the invoices. It merely uses the invoices as security against which it can receive funds from third-parties.

2) Visibility

When a business factors its invoices, the factor deals with the customers to receive the value of the invoice. While it can be great for the business as it means it doesn’t have to deal with customers anymore, it can damage its relationships with customers.

That is because factors may use different techniques to recover balances, some of which the customers may consider aggressive. On the other hand, the business is responsible for the recoverability of invoices in discounting. Therefore, no third-parties deal with customers.

3) Adjustments

When a business enters into a factoring agreement, it receives advance funds for each invoice factored. The factor makes adjustments to the funds that the business receives daily.

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On the other hand, the business controls its invoices in a discounting agreement. It usually provides a regular reconciliation of the account that reflects any changes in the level of debt that the finance provider.

The finance provider may make adjustments to the funds provides to the business. However, these adjustments are much larger as compared to discounting.

4) Risks

With factoring, the factor faces a much lower risk as compared to discounting. It is because factors have a higher chance of recovering invoices as compared to businesses due to their expertise. Even if there is an invoice that the factor cannot recover, the business is responsible for it. It means, there is a small risk for the factor if any.

On the other hand, the finance provider in discounting faces a higher risk as compared to factors. That is because the provider does not directly deal with invoices or recoverability. To tackle this, invoice finance providers apply certain checks to ensure the credibility of the business.

Conclusion

Managing accounts receivable and payable is crucial for a business. Businesses may have dedicated credit control departments to manage accounts receivable.

However, in some cases, they may use other resources to receive an earlier settlement against accounts receivable. The two main methods include factoring and discounting. Factoring involves a business selling its invoices to a third-party known as a factor.

Discounting, on the other hand, is when the business uses invoices as security to receive funds from third parties. Factoring and discounting are similar as they help the business receive finance through accounts receivable. However, they may also have some differences.

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