Factoring means selling the invoices raised to the customers to a third-party who make the payment immediately after reducing a discount. Bill Discounting provides immediate operating capital by borrowing against the invoice raised to the customers. Both are means to short-term capital for running operating expenses.
Factoring and Bill or Invoice Discounting have been long established as reliable and widely used means of the short-term finance. Companies and manufacturers have short-term sources of financing needs to run the day-to-day operations. When a finished product/service is produced/rendered, the invoice or bill to the customer is generated. The customer can take few days to months’ time to pay as per their own liquidity and terms of the sale. For long-established customers, a “credit period” is common and the proceeds are shown as “Accounts Receivable” for the future in the books of the company.
This can produce a cash crunch to purchase raw materials and other inputs to keep the operations running. To tackle this cash crunch, bill discounting is one of the common methods along with factoring.
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When a company issues a Bill of Exchange to the seller in lieu of the products/services purchased, it issues a “Promissory Note” or the promise to pay at a later date. When the seller goes for discounting, it presents this promise to a bank who purchases this bill, before its due date and pays the seller, the amount on the invoice after cutting a certain percentage called as a “Discount Charge”. This is actually like an advance against the bill which is like a security with the bank and the discount can be looked at like an interest paid to the bank to take up that credit instead of the seller. For a detailed understanding, read our post on INVOICE DISCOUNTING.
Factoring is similar to bill discounting in many markets. It entails a bank or third-party intermediary buying the invoices at a value less than the actual total value (face value) of the invoice. This discount usually varies from 2 to 6 percent. Here the chunk of the invoice face value is paid to the seller called as “Advance Rate”. Factor companies can release the money within 24 hours to the seller and he can get instant liquidity to continue operations. The remaining of the face value of invoice can be paid once the buyer’s payment is received by the seller’s bank. For a detailed understanding, read our post on FACTORING.
There can be various terms of the contract under Factoring and these can be utilized to set conditions for the cash management of the company. The upward cycle of companies and growth prospects helps them get credit purchases from a lot of sellers as their creditworthiness is high.
Difference between Factoring and Discounting
The main differences between the two can be explained as follows:
Control of Sales Ledger
In factoring, the bank giving credit takes the onus of checking on the sales ledger, control of credit and chasing your clients for paying back. The work of collection and follow up is outsourced to the bank. Whereas bill discounting requires your own accounts team to take care of the sales invoice, follow-ups and the money is paid directly to you.
Size of the Business
Factoring is useful for larger businesses where an entire line-up of client credits have to be managed. Bill discounting might be useful for small businesses where you do not want your clients to deal with your bank/ third party intermediary and give them an impression of your cash flow situations. Also, bills might not be available on a continual basis for discounting.
In factoring the client settles their payables with the factor (such as a bank). In bill discounting, the client will not really know the involvement of a third party. The transaction happens between banks where the confirming bank or the buyers’ bank does not intimate the seller of the reimbursement instruction but deals with his bank directly to determine the discounting terms.
Taking factor services allows you to focus on your business and the factor who is an expert in this field can provide a line of credit to you along with collection services. Bill Discounting requires your team to be involved in the entire process of recovery.
Amount Received by the Company
The drawer company (which is the seller) receives the amount minus a small discount immediately in a bill discounting. Factor companies can release the money within 24 hours to the seller and he can get instant liquidity to continue operations. Here the chunk of the invoice face value is paid to the seller called as “Advance Rate”. The remaining of the face value of invoice can be paid once the buyer’s payment is received by the seller’s bank.
Compensation to Bank/Financier
The bank receives discounting charges for the credit and in factoring it charges commission along with interest.
Factoring is only under recourse – i.e if the customer fails to pay to the financier, the credit has to be paid by the seller. In bill discounting, there are two methods to present the bills to the buyer’s bank – with recourse and without recourse
Businesses giving 30- 90 days credit in their production and payment cycle can make use of either of the services. Construction, clothes and apparel manufacturers, wholesalers, courier companies and various other manufactures can make use of these.