Invoice financing is perhaps one of the lesser understood and underutilised lines of business lending available. Nevertheless, invoice financing can be a powerful way for a business to access low cost, low risk, short term credit. Let’s take a closer look at what exactly it is, just how it works and what the major pros and cons of invoice financing are.

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What Is Invoice Financing?

Invoice financing is a way in which a business can borrow money based on what its customers currently owe in future revenue. When seeking invoice finance, a business effectively uses its unpaid invoices as a form of collateral to obtain fast credit from lenders.

There are 2 types of invoice financing which we will examine in more detail shortly.

How Does Invoice Finance Work?

The concept of invoice financing is relatively straightforward. Rather than waiting weeks or months for a customer to pay an invoice, a business can obtain a loan against invoices and borrow most of the invoice value more or less immediately. This can be very useful for a business experiencing temporary challenges with cash flow; remember, many businesses invoice terms allow between 30 – 90 days for payment and this can sometimes prove to be a long time to wait.

Lenders will generally advance the business around 85% of the invoice’s value. The lender will of course levy fees and interest which typically range from 3 – 5%.

Note that a business can choose to finance an entire customer account (this is known as spot financing) or just a particular invoice (known as selective financing or invoice trade).

Types of Invoice Funding

There are 2 different variations of invoice financing that a business may be eligible for.  Let’s look at them both.

Invoice Factoring (Or Invoice Factoring Loan)

Invoice factoring essentially means that the business effectively sells on its invoice and as such, surrenders its credit control rights to the lender. Under invoice factoring, the lender chases the customer and takes the payment for the invoice. In cases where the business has only financed a percentage of the invoice, the lender might pay the surplus back to the business after the loan, and associated costs have been repaid.

Of course, the customer may be somewhat surprised at being chased by a 3rd party lender for the invoice – especially in cases where they are still within the payment terms. This may negatively impact the relationship between the business and the customer who may feel they are being unfairly hounded by a debt collector.

Invoice Discounting

Invoice discounting is where the business retains conduct of the credit control. The business chases the customer for payment of the invoice as per its usual, standard practices and once payment is received, the business must repay the lender.

Whilst most businesses usually prefer this version of invoice financing, not all lenders offer it and those that do, usually only offer it to businesses with strong credit profiles.

Pros of Invoice Financing

Invoice financing offers multiple benefits for applicants. Let’s run through them:

Fast Cash – Invoice payment terms typically run anywhere between 30 – 90 days. Whilst some businesses can comfortably wait, others, especially smaller ones cannot. Invoice finance can allow a business to access up to 85% of its forthcoming revenues within a few days.

Low Risk – Invoice financing is relatively low risk. The only collateral required is the invoice which is being financed and as such, the businesses assets are not at risk like with other forms of unsecured loans.

Low Cost Credit – The fees and interest charges for invoice financing generally run between 1 – 3% of the invoice value (note that the larger the invoice, the lower the interest rate will be). That works out cheaper than many other forms of credit.

Cons of Invoice Financing

All forms of business borrowing carry some inherent drawbacks. Now let’s take a look at some of the cons of invoice financing;

Damage To Client Relationship –  Many customers may not appreciate being chased for payment by 3rd party finance companies. In some cases, it may even jeopardise valuable business/client relationships.

Not Risk Free – No lending is risk free. If the end customer goes bust and is unable to repay the invoice, then the business still needs to repay the amount borrowed to the lender and risks debt collection action and damage to its credit rating.

Costs Can Add Up – An overreliance on invoice financing will mean that the costs soon begin to add up.  For example, financing every single invoice would mean a business incurring 1 – 3% costs on the entire annual turnover.

Impact on Credit Rating – Before releasing the money, a lender will conduct credit searches on a business. These searches will be recorded on credit agency databases and may ultimately lower a business’s credit rating.

Who May Be Eligible For Invoice Financing?

It is important to understand that invoice financing is only really applicable in certain circumstances. Firstly, many lenders will only finance business-to-business invoices. As such only businesses that service other business clients are eligible. For example, Triumph Business Capital states very clearly that they work exclusively with B2B clients. Another prominent invoice finance provider Altline however, will consider financing non-business invoices depending on the particular industry, and Payplant financial are even willing to work with Amazon sellers.

Speaking of industry, this is also another important factor. Some invoice finance providers are unwilling to work with businesses operating in particular industries such as insurance, logistics and or medical receivables. Restricted industries will usually be advertised pretty clearly on their websites to save prospective clients from wasting their time.

Most lenders will also only consider businesses with at least 12 – 24 months of trading history so it’s not an ideal form of start up financing.

Additionally, before lending, the lender will want to take a good look at the business’s credit history. Whilst they are not permitted to credit check the customer that owes the invoice, they will ask for evidence that the customer has paid invoices in a timely manner previously. As such, a business may be required to supply a lot of sensitive information in order to obtain invoice financing.

Final Thoughts

No form of borrowing comes for free and no lending is risk free either. However, invoice financing represents an excellent option for eligible businesses in need of fast, low risk, low cost credit. Whilst it should not be relied upon too much, it can be a valuable tool to overcome short-term cash flow issues.