What is invoice finance? How it can help your business

Doug Saunders ACA explains how you can make use of invoice financing to obtain immediate cash.

If you need to access money to help in the immediate running your business, how do you do this without getting saddled in debt?

What options can you pursue to raise finance in the short term?

Obtaining a loan is a long term option, and the interest on it can prove expensive to your business, potentially eating into your budget. Alternatively, you could raise finance by taking on investors but again, this may be too time consuming and permanent for your cash needs. It also dilutes your shareholding and adds another potential layer to strategic decision making.

This is a problem common to many owner managers, raising restrictive debt or sacrificing equity? Neither provide a solution for instant financing requirements. Thankfully an alternative you can consider is to raise money against unpaid invoices. A lender uses an unpaid invoice as security for funding, allowing a business quick access to finance based on a percentage of that invoice’s value.

Known as invoice financing, we explain how you can make use of it, the different options available, and the various costs involved. This blog post covers specifically:

What is invoice financing?

Invoice finance works whereby unpaid invoices are used as security for issuing lending to a business. Businesses can therefore borrow against their accounts receivable to obtain money inside their usual payment terms.

Outstanding customer invoices can take potentially weeks, or months, to be processed. Invoice financing helps businesses release some of that money far quicker. In that sense it's a fast and flexible approach to manage cash flow and receive payment for products sold, or services provided. 

Also known as an asset-backed financing option, it's an option for all types of businesses that frequently bill other organisations (B2B). There are different types of finance available, and these include:

• Invoice factoring
• Invoice discounting
• Spot factoring

How does invoice financing work?

Unpaid customer invoices are ring fenced as money that is owed to your business. A lender then purchases those outstanding invoices at a discounted rate to their total value. Depending on the type of invoice finance you agree to use, the lender can also take on the requirement to chase those liabilities, thereby potentially taking it off your hands. Alternatively there are options where you can still handle that yourself.

This method of finance can be particularly helpful with managing short term credit. The reason being, by using invoice financing you can be paid up to 95% of the invoice amount within as little as 24 hours of issuing it. This approach means your invoicing doesn’t need to change, so you can carry on business as normal. 

Invoice finance can work as follows:

• Invoice customers as usual for completed work, or sale of goods
• The first instalment, up to 95% of the invoice value, is paid out to you straight away
• The remainder is then paid to you on receipt of the customer’s payment, minus any fees and service charges

Advantages of invoice finance:

As with any funding option, there are both pros and cons to committing to invoice financing. Some of the advantages of choosing either option is as follows:

• Speeds up the working capital cycle - Instead of waiting for weeks, or months, for customer payment, an agreed percentage of the invoice could be in your business bank account potentially within 24 hours after issuing it. The increasing of working capital can help fuel growth. 
• No fixed assets are needed - There is usually no need to offer assets as security for the loan. This might be helpful if your business has few fixed, physical assets.
• As your business grows, so does the amount you can borrow - The availability of finance is based on the value and quantity of your invoices. So as your revenue increases and you scale-up, so does the amount of funding you can potentially obtain.
• It may be easier to get than other types of business loan - Your business credit history is considered, but the focus may be more on the creditworthiness of your customers and the value of the invoices, as opposed to matters such as limited operating history.
• It can save you time - Some invoice financing options include complete outsourcing of your credit control function, so you can spend time focusing on other key areas of the business.

Disadvantages of invoice finance:

Some of the main restrictions to consider include:

• You won’t receive the full value of the invoice - The lender will deduct fees and interest. If you want to end the agreement early, you may be charged a termination fee, or be expected to give a notice period.
• It may cost more than other types of business borrowing - Factoring fees may be higher than traditional business loans. You should compare a few providers to find the best agreement and value for you.
• Your customer may know you’re financing their invoices - If the provider manages the chasing of customer payments, then your customers could become aware of the arrangement. It’s however, possible to keep this in-house through invoice discounting, if you would rather keep it confidential.
• It’s usually just a short-term solution - Contracts are usually between 12 and 24 months, so it’s sensible to prepare so cash flow isn’t an issue once the agreement ends.

What are the typical invoice finance rates and fees?

There are different fees that providers can charge based on the type of service a business needs. The charges can vary depending on the lender. There are various factors that influence fees such as the sector you are in, trading history, the volume of your invoices, invoice value, and the amount of time a customer takes to pay.

You’ll pay a discount charge for releasing the cash, as a percentage of the invoice value. You’ll also pay a service charge, which could also be referred to as a credit management fee. If the lender takes over the credit control, then the service charge will be higher than if you keep this in-house.

There may also be additional costs, such as a termination fees (namely if you want to end your agreement early), facility fees, checking the business finances, overdue fees if customers don’t pay up on time, and credit protection fees. So, it’s crucial to read the terms of the agreement very carefully to ensure you're fully aware of all potential charges.

While fees are important, you’ll also want to be sure of the quality of service. So, take the time to compare your options and check customer feedback. If the lender will be dealing directly with your customers regarding making payment, this may be a key consideration to ensure customer relationships are maintained.

The different types of invoice financing

1. Factoring:

Invoice factoring is a process where the funds are made available to you by the lender for immediate use, these funds are are based on raised sales invoices. The main aim is to ease the burden of lengthy payment terms and sales ledger management.

This is achieved by providing you with an advance based on a percentage of your debtor ledger. The factoring business will then manage your sales debtor ledger and handle the credit control on your behalf.

When factoring, you may carry on raising and sending out invoices as usual whilst also sending a copy of the document to the factoring business. The factor will provide funds for up to 95% of the invoice value available to you after receipt.

This frees you up to concentrate on managing your business by eliminating the time-consuming task of chasing up customers that owe you money.

2. Invoice discounting:

Invoice discounting works in a similar way to factoring but is more straight forward and is usually only available to larger, more established businesses. In this instance, you still draw money against your invoices in advance of your customers paying. The difference is that you retain the credit control function in-house and you continue to handle the collection of money yourself.

This means invoice discounting avoids a third party lender dealing directly with your customers.

3. Spot factoring:

Spot factoring provides greater flexibility for a business. In effect spot factoring is where a business sells an unpaid invoice to a spot factoring company on a one off basis.

This method gives a business owner greater freedom in that you can select which invoices you can use to generate the working capital. Traditional invoice financing methods typically require  all B2B invoices be passed to the invoice finance providers.

Spot factoring means there is no minimum contract length required. To meet your businesses cash flow needs, you can use this service more frequently. Invoices requiring payment are forwarded to the spot factoring business. They will make a payment of up to 75% - 85% available to you, again with the balance being payable less charges when the invoice is finally settled.

Spot factoring advances are typically less than invoice factoring and discounting.

What is the difference between invoice factoring and invoice discounting?

Applying for invoice financing can be done either directly with a finance business, or through a broker. Typically, you can check your eligibility and apply online. There are also some options for managing your account online. The lender, your business, and the type of financing you've chosen will all have an impact on the application procedure and documents needed.

At the very least, you'll typically be required to provide financial information, such as a list of your clients, and the amount of any unpaid invoices. In addition, you'll be questioned about the sector you operate in and projected annual revenue. The provider might also request financial statements for auditing and running business credit report checks.

The content of this post was created on 16/01/2023 and updated on 23/01/2023.

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