What is invoice financing, and how does it work?

Invoice financing is a way for businesses to borrow money against unpaid customer invoices. But how does it work, and what are the drawbacks?

Holly Bennett Last updated on 01 July 2021.
What is invoice financing, and how does it work?

According to the Federation of Small Businesses (FSB), around 50,000 small companies close each year due to the impact of late payments.

If unpaid customer invoices are affecting your cashflow, invoice financing may be an option. You won’t get the full value of the invoice, as fees and interest are deducted, but you can access the cash without waiting weeks or months for customer payment.

What is invoice financing?

Invoice financing is an agreement with a lender that lets a business borrow money against unpaid customer invoices for a fee. The lender uses these invoices as security to release an agreed percentage of the value of the invoices, which is advanced quickly – sometimes within just 24 hours.

Depending on the type of invoice financing, the lender, which may be a specialist invoice financing company, bank or other financial institution, may also collect payment from the customer on behalf of the business.

How does invoice financing work?

Once a business has sent invoices out to its customers and a copy to their provider, an agreed percentage of the total value of the invoice is deposited into their business bank account.

Depending on the agreement, the business or the provider sends reminders and correspondence relating to the outstanding payment to the customer.

Once the full amount has been paid by the customer, the business either pays the provider for the service, or the factoring company sends the business the remaining amount, minus their fees and charges.

What are the advantages of invoice financing?

If your cashflow is sometimes affected by late payment of invoices, invoice financing could free up cash much sooner than waiting for customers to pay invoices. Having reliable access to most or all the cash owed to you by your customers could bring greater flexibility, a predictable income, and easier financial planning. You can spend the cash on anything from paying staff wages to developing your growth plans. And as your revenue increases, the availability of finance for working capital does too.

Some invoice financing options include complete outsourcing of your sales ledger process, which might appeal if you want to free up that time to spend on other areas of your business.

What are the disadvantages of invoice financing?

Invoice financing services don’t come free, and you won’t receive the full value of the invoice, as the lender will deduct fees and interest charged. Also, some providers charge a termination fee if you want to end the agreement early.

Much like business loans, the provider will carry out credit checks when you apply, which could affect your credit report. And, depending on your agreement, if your customer doesn’t pay their invoice, the provider may hold you accountable, known as recourse factoring.

If the provider collects customer payments direct, your customers will be aware of your arrangement, which may affect your reputation and any relationship you’ve built with them.

Contracts can be from 12 to 24 months, so it isn’t a long-term solution. Consider what preparations you can make so cashflow isn’t an issue for your business once the agreement ends.

Which type of invoice financing is right for my business?

While most types of invoice financing can provide timely access to money your customers owe your business, there are a few differences based around who controls the sales ledger, and whether your customers are made aware of the arrangement.

Invoice factoring

This type of invoice finance involves the factoring company taking control of the sales ledger operations of the business, as a package of services.

The provider gives the business a percentage of the value of each invoice upfront, before collecting the money owed by each customer. As much as 95% of the invoice value may be advanced. When the total amount is received, the provider pays the business the rest of the invoice value, with fees and interest deducted.

Advantages of invoice factoring Disdvantages of invoice factoring
  • More time to focus on other business matters, as the provider collects payments.
  • The provider usually credit checks your customers.
  • Reliable and timely access to money owed.
  • Your customers will know you’re using a factoring service.
  • You pay for the sales ledger service, so it may cost more than invoice discounting.
  • Your customers might dislike not being able to deal with you direct about their invoices.

Invoice discounting

This is similar to invoice factoring, as the business borrows cash against the value of their unpaid invoices at an agreed percentage of the overall value. The provider will advance as much as 85% of the invoice value. Fees and charges are deducted from the remaining balance, and remitted to or claimed by the lender.

The main difference is the provider doesn’t manage the business sales ledger or provide debt collection services. So you maintain control of issuing reminders and collecting payments.

Advantages of invoice discounting Disadvantages of invoice discounting
  • Your customers won’t know they’re dealing with an invoice financing company.
  • Keeping management of your debt collection might help maintain close client relationships.
  • Typically lower charges and fees than factoring.
  • You remain responsible for your sales ledger and credit control.

Selective invoice finance (SIF)

With this type of invoice finance, sometimes known as spot factoring, you choose which specific invoice or customer account you want to finance. So it’s a more flexible option if you’re not looking to outsource your whole sales ledger.

Advantages of SIF Disadvantages of SIF
  • Fees are only applied to invoices you choose to fund.
  • There’s no contract tie-in.
  • You won’t need to pay for management of your entire sales ledger.
  • Your selected customers will know you’re using a factoring service.
  • For multiple invoices, it may be more cost-effective to use factoring or discounting.
  • It can be harder to secure than other types of invoice financing, especially for small businesses.

How to apply for invoice financing

You’ll usually need to meet strict criteria to access invoice financing. Most providers will insist on a minimum annual turnover, and that you have an established trading history.

Am I eligible for invoice financing?

To be considered, you’ll need to:

  • meet minimum turnover requirements
  • be registered with Companies House in the UK or Ireland
  • sell to commercial customers, not members of the public
  • sell on credit terms
  • have a strong credit history
  • provide evidence of your trading history

If you fit the criteria and want to apply, make sure you shop around for the best deals.

There are huge variations in the fees and percentages charged by different providers, and you’ll want to be sure of the quality of service, so take the time to compare your options and look at customer feedback. And make sure you’re clear about the fee structure and terms involved in the agreement, such as the maximum for overdue accounts, before you go ahead.

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About the author:

Holly champions clear, jargon-free writing. She’s been creating finance content for leading organisations for over 10 years. Read more

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