Supply Chain Finance or Invoice Factoring: Which Is Better for Managing Cash Flow?

What is supply chain financing?

Supply chain financing, while a little complex, is a useful small business tool. It gives small businesses the opportunity to extend payment dates to suppliers without any impact on their credit scores and without the suppliers losing money.

In this scenario, the supplier can receive advanced payment on the outstanding invoices from a third-party funder. When the payment date comes for the small business a few weeks later, the business fulfills the payment and the money goes to the funder or supplier, depending on which holds the account at that time.

To be clear, this supply system is not a debt or a loan ― it’s a tool small businesses and suppliers can use to free up capital via a third-party funder. While third-party funding institutions may charge a fee for each transaction, this is not an asset-based lending program. This is the main difference between supply chain financing and invoice factoring. [Read more on what is good or bad debt.]

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What is invoice factoring?

Unlike supply chain financing, invoice factoring is a type of small business loan. Invoice factoring is a tool businesses can use to get money on outstanding invoices immediately. They work with a third-party lender that will buy outstanding accounts receivable (A/R). While it may sound similar to supply chain financing, this is an asset-based lending program where a company’s A/R acts as collateral.

Invoice factoring can be a quick, easy way to get cash up front. Keep in mind that factoring companies will charge fees for each transaction and may buy A/R at discounted rates. [Learn more about alternative lending.]

Supply chain financing vs. factoring: What’s the difference? 

Unlike factoring, where a supplier sells its receivables at a discount to a third party (a factor) for early payment, supply chain finance is a financing solution initiated by the buyer where the buyer agrees to pay an invoice early for a discount. The benefit to the buyer is a discount on the invoice price.

The benefit to the supplier is early payment, usually at a discounted rate less than factoring. It’s a new electronic take on the old 2/10 net 30 payment term, but the buyer initiates the request for early payment through the use of technology. [Explore how to apply (and get approved) for a business loan.]

Pros and cons of invoice factoring

Pros

• You get quick access to capital: Applications for invoice financing are usually quicker and require less paperwork compared to other types of business loans. It is easier and more accessible for business owners to get approved for these loans, and cash can be transferred directly into your business bank account.
• A/R is responsible for final payment: Invoice factoring is unique compared to other loans because it sells unpaid customer invoices from their A/R to third-party companies. In the short term, this allows businesses to access cash for short-term financing without impacting their current funds. Instead of liquid cash being impacted by this loan, it is the sold invoices that become collateral.

Cons

• Your A/R is treated as collateral: When you sell your receivables, you access invoice payments earlier but as a liquid asset. To access the loan, you must sell the unpaid invoices, leading to them being used as collateral.
• You may not receive the full amount of an outstanding account: By selling A/R to a third-party lender, you may be charged a fee for these transactions. These companies could buy A/R at a discounted rate instead of for the full amount. It is not guaranteed you will be able to sell the invoices for the full amount.

Pros and cons of supply chain financing

Pros

• It’s not an asset-based lending program: As supply chain financing is not a debt or a loan, this type of financing involves a direct relationship with a third-party funder to fund early payments of invoices for the business. Although the funding institution can charge a fee, there are no debts or penalties associated with it.
• It’s a fast way to free up cash: If your business needs cash quickly, financing allows you to receive funds faster because invoices are being paid in advance. If your business is being paid faster, you can use your cash quickly.

Cons

• The third-party company may take a small fee: You may lose out a small portion of your income through financing. The third-party funder and/or supplier receives early payment, and the negotiation would be a fee for this accommodation. Usually, supply chain financing is provided by large corporations.

Will supply chain financing replace invoice factoring?

Supply chain financing does not change the unbalanced relationship between big buyers and smaller suppliers. Factoring has been around for hundreds of years because when a smaller supplier sells to a bigger buyer, it is the bigger buyer who determines when they will pay their invoice, often regardless of the payment terms they agreed to.

Supply chain financing does not change this relationship. It is initiated and controlled by the buyer. The buyer decides which suppliers can participate, how quickly they will pay and what discount they will demand. Some buyers may not have the money, technology or interest to offer it to all their suppliers, offering it only to their biggest suppliers. Others may offer it today only to take it away tomorrow without notice because of changes in their cash flow position or priorities. The power remains with the buyer, and the supplier remains at their mercy for payment.

Invoice factoring gives you more control.

Factoring changes this dynamic because it is initiated and controlled by the supplier. With factoring, the supplier determines which invoices they will factor and when based on their cash flow needs. They are in complete control. They know the cost ahead of time and can factor it into their pricing.

Technology is making invoice factoring paperless.

One drawback of factoring is it could be labor-intensive, with copies of invoices needing to be submitted to and verified by the factor. The increasing use of technology such as e-invoicing and e-payment makes factoring easier and more streamlined. Online vendor portals make it easy for a factor to view and confirm invoices.

Should you take part in a supply chain finance program?

Supply chain financing can be a great option for a business that is trying to access cash without immediate debt or penalties. If you are getting paid earlier, it allows more flexibility for spending, growth and security for your company. Additionally, it can positively impact your balance sheet as you would be removing a factor due to selling the invoices.

On the other hand, supply chain financing may not be the best option for every business. Some third-party funders may want all of your receivables, giving no room for flexibility. As a business, you may not be able to decide which receivables you would like to consider for financing. In most cases, you also will not be able to use the same receivables for additional loans as they are already associated with the financing option. Along with a fee for a third-party agency to purchase the receivables, there may be a factoring fee you must pay the funder.

Many supply chain finance programs are offered by large corporations. Examples include suppliers, such as Amazon, Walmart, Coca-Cola, Warner Bros., Nordstrom and Bell. Some of these corporations use their own cash to fund the programs, while others have partnered with banks or hedge funds to fund early payments to suppliers.

If one of your customers invites you to participate in their supply chain finance program, you should ask yourself, “Has anything really changed?” Yes, you may get paid sooner for a discount, but you may not. What guarantee do you have that it will be available on your next invoice, and on the one after that?

With factoring, you are in control. You determine which invoices you will factor and when to meet your ever-changing cash flow needs. You deal with one factor for all of your invoices instead of working with a different program, process and platform for each customer.  

Anne MacRae and Matt D’Angelo contributed to this article. Source interviews were conducted for a previous version of this article.