Invoice finance is a form of financing that allows businesses release capital from unpaid invoices. It enables businesses to get their hands on cash owed to them much faster and in some cases instantly, supporting a positive cashflow, growth and development.
Whether that means having the cash to buy new materials, invest in property or acquire a new branch, invoice finance can help companies to solve the problem of lengthy invoice terms and slow-paying customers. This guide will take you through the ins and outs of invoice financing, including the following key sections:
- What is invoice finance?
- How does it work?
- Types of invoice finance (factoring & discounting)
- Advantages and disadvantages
- Is your business eligible for invoice finance?
- How much does it cost?
- Case study
- Final thoughts & FAQ’s
What is invoice finance?
With invoice finance, a business sells their unpaid invoices (accounts receivable), to a third party for a percentage of their value. The existing invoices serve as security for the lender, who then provides the borrower with a percentage of the outstanding invoices upfront, as a loan. This advance enables the business to leverage their sales ledger, increasing the cash moving through the company and injecting cash into their working capital.
Invoice financing is a flexible type of borrowing. As it bases itself on cash that’s due in soon, firms can grow their borrowing power as turnover increases. Invoice finance, otherwise known as debtor finance, is an umbrella term covering a range of asset-based financing facilities. There are two primary forms of invoice finance: invoice discounting and invoice factoring.
Invoice finance enables businesses to access cash upfront for unpaid invoices, instead of having to wait weeks or months for their customers to pay their bills. It’s can be a useful asset-based finance solution for any business struggling to bridge the gap between accounts payable and accounts receivable – in other words, cash in, and cash out.
How does it work?
Once the customers pay their invoices, the lender provides the remaining balance, minus their fee. Companies using invoice finance can get hold of their advance typically within 24-48 hours of creating an invoice, meaning they have a rolling cash flow throughout the month, rather than waiting for customers to pay within their 30-, 60- or even 90-day payment terms.
As a company grows, their invoice finance facility can grow to match, in some cases covering their entire sales ledger. This flexibility means that companies experience their growth tangibly and can continue to expand and invest as their turnover increases. Invoice finance can improve a company’s Working Capital Cycle (WCC), this is why debtor finance is also sometimes known as working capital finance.
Types of invoice finance
As mentioned, there are two primary forms of invoice finance, being invoice discounting and invoice factoring.
With invoice discounting, you still collect and manage your invoices yourself and deal with your customers directly. As soon as your complete work for a customer or fulfil an order, you send the invoices to your customers as usual, sending a copy to your lender at the same time. The lender deposits the agreed portion into your account, usually within 24-48 hours, and your customers pay your business as normal (with your business paying the lender once the customer has paid the invoice).
A major advantage of using invoice discounting is that you retain control over your sales ledger. You have the responsibility of interacting with customers and chasing late payment.
Selective invoice discounting
A sub-form of invoice discounting is selective invoice finance, sometimes known as single invoice finance or spot factoring. This form of finance works in the same way as invoice discounting but has the added benefit of allowing the business to control which customers or invoices are discounted. Companies with selective invoice discounting in place get to choose the invoices they would like to factor, rather than committing to a contract which covers their whole sales ledger.
Selective invoice finance is often a good option for companies that have unpredictable cash flow only at certain times of the year, or have one particularly large client that can throw their cash flow off balance. While this affords companies more flexibility in their finance provision, it provides less security for the lender, which means the rates are usually higher. Lenders will also want to vet your customers more thoroughly before they agree to selective lending.
Confidential or disclosed invoice discounting
Many companies opt for confidential invoice discounting, which means customers will be unaware that you are using a finance provider. This is a favourable option for most companies, as customers may mistrust third-party involvement and, in some cases, will seek services elsewhere if they are aware that your company is borrowing money.
If your invoice discounting facility is disclosed, however, your invoices will be marked with a ‘notice of assignment’, telling your customers that invoices are assigned to an invoice provider. While you will still retain control over your sales ledger and are responsible for chasing payment, your customers will pay your finance company directly. Disclosed discounting is usually more expensive than confidential discounting due to the administration fees involved. It’s worth considering which option is better for your business, if you rely on maintaining strong customer relations confidential is often preferable.
Invoice factoring differs from invoice discounting in that the lender assumes control over your sales ledger. Customers will be required to pay the lender directly, and it will be down to the finance provider to chase late payments. Some businesses favour this form of finance, as it frees up their time and resources to put towards other tasks and projects. However, it can damage your customer relations depending on how the lender handles customer service or chasing of payments in relation to invoices.
Invoice factoring tends to be more expensive than invoice discounting, as the lender takes on the work involved with maintaining your sales ledger. This control also means that many invoice factoring contracts are significantly longer than any you might have with invoice discounting (to offset the lenders fixed costs in setting up the facility). It’s more cost-effective for a company to assume a larger sales ledger, either with more clients or bigger invoices, or control your sales ledger over a longer period, to minimise their administration costs.
Confidential invoice factoring
It is possible to set up a confidential factoring facility. Not many providers offer this product as it presents more work, risk, and costs to the lender than a disclosed facility. The factor still controls your sales ledger but introduces themselves differently to your customers. Instead of using their own name, they will act as your account department, operating under your business name when dealing with your clients. Typically a dedicated phone line will be set up for customers to call and arrange payments. The lender handles the calls, but answers in your name.
Advantages and disadvantages of invoice finance
Both options can mean a rapid boost to your pot of working capital, providing a solution to cash flow issues and opening opportunities for growth and investment. Invoice finance (also known as accounts receivable finance) is relatively low risk for both the borrower and lender, as it’s based on money soon to come in. Both forms of accounts receivable financing are some of the fastest finance solutions on the market when it comes to financing, as you can typically receive an advance within 24-48 hours.
There are lots of advantages of invoice finance as a source of finance for your business. That said, as with all types of funding, there are also potential downsides. Take a look at the major pros and cons of each form of invoice finance below to assess further which solution is better for you.
Advantages of invoice factoring
- The finance company looks after your sales ledger, managing the credit control process and chasing payments, meaning you have more time and resources for other tasks
- They often have a comprehensive credit checking processes, enabling vetting of new customers
- Factoring companies can sometimes help you negotiate better terms with your suppliers
- Invoice factoring is open to smaller businesses, unlike discounting
Disadvantages of invoice factoring
- Your customers will be aware that you are using a finance company, which can damage valuable customer relationships, and in some cases cause them to look for services elsewhere
- Invoice factoring tends to be more expensive than invoice discounting, owing to the extra management they assume
- Invoice factoring agreements tend to be long-term, which can lose you profits in times you don’t truly need a financing facility
Advantages of invoice discounting
- An invoice discounting agreement is often confidential, protecting your customer relationships
- You maintain control over your credit control processes and debt collection, meaning you can continue to fully manage relationships with key clients
- Invoice discounting is usually cheaper than factoring as you maintain control over your sales ledger
- A discounting facility is usually more flexible with no long-term contracts, having the option of single invoice finance.
Disadvantages of invoice discounting
- Discounting is usually only available to SME’s and larger companies with more than £100,000 annual turnover
- Invoice discounting providers will want evidence that you have robust credit control processes and reliable customers
- Some businesses can become overly reliant on invoice discounting and find it difficult to function without it.
On the whole, if you own a smaller business that has trouble chasing customers and collecting payment, factoring is likely to work better for you. Factors are experienced in credit control, and you’re likely to see fewer unpaid invoices. However, for companies with reliable customers and a more substantial turnover, invoice discounting is a cheaper option for businesses who can manage their credit control in-house.
Is your business eligible for invoice finance?
Your eligibility for invoice finance will depend on several factors. Mostly finance providers will want to verify how creditworthy your customers are and see information on the time frame of their payment terms as well as the size of their invoices.
Your eligibility will also depend on what type of invoice finance you choose. Some businesses may be more eligible for discounting rather than factoring, and the other way around.
Factoring requires more documentation
Factors generally require more documentation upfront than invoice discounting providers, as the lender is assuming more responsibility, and therefore liability, with regards to credit collection and control. If you are seeking a factoring facility, the lender will want to see a number of documents, including:
- a detailed list of your customers
- your finances for audit
- your sales ledger
- details of outstanding invoices to be funded.
In some cases, the factor will also require a written guarantee from the company director. It’s a good idea to have these documents ready before applying, as any missing paperwork can lead to significant delays.
Who uses invoice finance?
Companies with a business model of providing services or completing work for customers who are invoiced afterwards can find invoice finance helpful. This business model tends to create a lag between the work being completed, for which you’ll need to have bought materials, invested in resources and paid staff wages, and the money coming in for such work. Customers often have 30-, 60-, 90- or even 120-day payment terms, extending this lag even further.
Invoice finance facilitates growth for companies operating in this way. A larger product will yield larger revenue, but it can be challenging to finance larger projects with the cash coming in at a date which is so far off. Advance payment makes growth more tangible. On top of this, any company that employs and remunerates staff on a weekly basis may find invoice discounting or factoring a useful financing tool. If your still unsure if invoice finance is for your business, take a look at examples of industries and businesses that typically use invoice finance to operate.
Most businesses in the construction industry have experienced cash flow issues. It’s notoriously difficult to keep cash moving consistently and regularly through a construction business, owing to several factors. Firstly, many construction firms experience seasonal fluctuations, with more work coming in in the summer months than in the winter. It can be difficult to manage these seasonal changes while still managing to pay the same wages to staff.
Secondly, many construction projects involve a long chain of contractors, suppliers and workers. If a company has to wait a long time for payment from higher up the chain, it prevents them from taking on new work. Invoice finance enables construction firms to unlock money tied up in outstanding invoices, allowing contractors or construction firms to bid for new contracts and invest in new materials. Many financiers offer tailored construction invoice finance specially designed for the industry.
Import & export
Companies who frequently deal in foreign trade (importing products or exporting goods overseas) can suffer from substantial cash flow issues. Payment can take even longer from overseas companies, as banks can be slow to convert currencies and make payments into foreign bank accounts. Companies in export trades are also likely liable for a considerable amount of extra fees and costs than local traders, having to adhere to various government regulations abroad.
Invoice finance can protect import and export companies against a cash flow freeze when there’s a delay in payment from overseas. Some providers offer specific invoice finance designed for import and export traders, known as import finance or export finance, tailored to the extended payment terms and issues that come from trading with other countries.
Recruitment companies provide temporary and permanent staff for a range of positions. The payroll pressures can be immense, having to remunerate contracted workers, temporary workers and permanent staff on a weekly and monthly basis.
Clients can take weeks or months to pay their invoices, creating a huge gap between the money going out and the cash coming in. Invoice finance can provide a stop-gap, relieving payroll pressures and allowing recruiters to take on more clients.
Wholesale and distribution
The wholesale industry deals with some of the longest credit terms there are, with many clients having up to 120 days to pay their invoices.
It’s also a very competitive industry where time is of the essence. Undercutting your competitors and bidding on new contracts is imperative to growth in this industry, which is difficult to achieve against the pressures of paying staff, keeping up to date with warehouse and storage costs and buying new stock.
Invoice finance can hugely increase the cash moving through a wholesale business throughout the month, allowing for a smoother Working Capital Cycle.
How much does invoice finance cost?
Most invoice factoring and discounting agreements comprise of two primary fees, the service charge and the discount fee. It’s also worth noting on top of these fees, many contracts include additional fees.
The first is the service fee, which equates to the cost of maintaining the facility. This fee goes towards the management of your account, and in the case of invoice factoring, the costs involved with collecting payment and administrating your sales ledger. For invoice factoring, this charge is sometimes called the credit management fee.
This fee varies depending on the size of your turnover. For invoice factoring, companies can typically expect to pay between 0.75% and 2.5% of their annual turnover for their factoring facility. Usually, the service fee is cheaper for an invoice discounting facility, often starting at as low as 0.25%. If your annual turnover shrinks or grows, your invoice provider will adjust your service fee accordingly.
The discount fee is the borrowing charge, calculated as a percentage of the invoice value. It’s the amount you pay in return for a lender releasing the advance to you, working in the same way as bank interest. For a factoring facility, this amount is usually 0.5%-5% of the total amount of the invoice. Again, the discount fee will be less for an invoice discounting facility, often not exceeding 3%. As a general rule, the higher the value of the invoice for which you want to receive an advance, the lower the discount charge will be.
Some companies include extra charges for certain services or offer add-ons for an additional cost. A lot of finance providers charge a fee for setting up the facility. Some charge an additional administration fee to audit your financial documents and many include a minimum usage fee which you’ll have to pay if you don’t process a certain amount of invoices per month. For a contracted factoring facility, there may also be an early termination fee if you wish to leave your contract before it elapses.
Before you sign an agreement, be sure to look at all the charges involved and ask for clarification on any points which aren’t explicitly clear, to avoid any costly surprises later on.
How are fees calculated?
How much you pay in fees depends on several factors, including the following.
Size and amount of invoices
The more invoices you want to release funds from, and the bigger they are, the lower your rate is likely to be. This is because it’s more cost-effective for a lender to set up a facility that you use regularly, or through which a lot of funds pass.
Some industries are risky by nature. Non-payment is a bigger problem in some sectors than others, and your credit protection charge will reflect this larger risk. This is particularly the case for non-recourse agreements.
Your business background
In the case of invoice discounting, lenders rely on your credit control processes to receive payment. They will want to see how robust your payment collection strategy is and which processes and controls you have in place.
Lenders will also want to see evidence of your trading history. They want to know how reliable your customers are and see proof that they usually pay up, and pay on time. Almost always, the more creditworthy your customers, the lower rate you’ll pay.
A London-based media company, started using an invoice finance company because their large blue-chip clients were taking between 90 to 120 days to settle invoices, and they needed to find a source of working capital to invest in new projects and fuel growth.
They had already taken out an overdraft from their bank, but this was expensive interest wise and not enough to solve their liquidity requirements. Retaining a good relationship with their clients was vital to their business model, therefore did not want a third-party factor to chase up their debtors. Thus the invoice auction model appealed to them as it meant they could select which customer invoices on which they would raise finance (and would only incur fees when they needed to use it).
This company now regularly uses the service to obtain instant cash of up to 85% of the value of their invoices, paying fees of on average 1.25% of the invoice value.
Final thoughts & FAQ’s
Invoice finance (invoice discounting and invoice factoring), is becoming a popular way for companies to get their operating liquidity flowing, vital for smooth-running daily operations and business growth.
As we’ve seen, invoice finance bases itself on money that’s soon to come in. As companies use their accounts receivable ledger as collateral, they are safe in the knowledge that the borrowed funds are almost guaranteed to come in within a matter of weeks or months. This security makes it an appealing form of borrowing for both the borrower and lender, reducing the risk for both parties as opposed to traditional finance (i.e. business loans, commercial overdrafts…).
Whether you opt for invoice factoring or invoice discounting will depend on factors such as the budget you have available, the size of your business and, principally, how much control your business needs over its sales ledger.
Whichever invoice-backed finance solution works best for you, both factoring and discounting can help to relieve the financial burden of extended payment terms and liberate cash tied up in invoices.
How quickly can I get invoice finance?
Invoice finance is quick and easy to set up. Most providers require only an online or telephone application and will approve your request within a few days. Once a facility is up and running, most lenders supply your advance within 24-48 hours of receiving an invoice.
What are recourse and non-recourse agreements?
When you acquire an invoice finance facility, your agreement will either be with recourse or without recourse. This differentiation determines who assumes liability for the debt, should a customer refuse to pay or default on their payment. An agreement with recourse means that you will still have to pay the lender, even if the customer payment doesn’t come through.
In practice for non-recourse agreements, the lender provides Bad Debt Protection, which safeguards your business against damage from an unpaid or delayed bill, almost like an insurance for your business. In other words, the lender assumes the credit risk, protecting your company from the threat of insolvency.
While a non-recourse agreement reduces the company’s risk, this reduced risk comes at a price. Non-recourse contracts are typically more expensive than agreements with recourse. In some cases, the portion of advanced cash will represent a smaller percentage of the invoice value. For companies with several high-paying clients, or any unreliable customers, the higher fees associated with a non-recourse agreement may be worth considering against the potential damage from a defaulting customer.
Finally, make sure you check the small print when it comes to a non-recourse agreement. Even in a contract without recourse, many invoice finance companies reject liability in certain situations. This is the case for some invoice disputes. Make sure that these terms are explicit, as you don’t want to pay a higher rate and take the hit from customer debt.
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Is invoice finance regulated?
Asset-based finance and thus invoice finance is not regulated in the UK, which means providers have free reign when it comes to negotiating their fees, contracts and products. They aren’t accountable to any industry bodies (unless registered with the ABFA), which means they’re under no obligation to adhere to any industry-wide standards or protocol. For this reason, it’s advisable to take time choosing a finance provider and you should always seek professional advice.