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Published 11 April 2024
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What is Invoice Financing and How Does it Work?

Invoice financing can make it possible for businesses to borrow money against unpaid customer invoices. But how does invoice financing work, and is it right for your business?

Invoice financing is a way for businesses to quickly access some of the money tied up in their unpaid invoices. Depending on the invoice finance arrangement, a finance provider may advance your business as much as 95% of the value of your unpaid invoices within 24 hours.

Since there are different types of invoice finance arrangements – and the details are likely to depend on the nature of your business – the specifics of invoice financing may vary. Generally, however, invoice financing is a way to quickly get hold of some of the money owed to your business without having to wait for your customers to pay.

Invoice financing is an increasingly popular solution for businesses struggling with cash flow, and an estimated 45,000 UK businesses already use some form of invoice finance. But as with all business decisions, there are advantages and disadvantages to invoice financing. Consider these carefully before you decide whether invoice financing might be right for your business. 

What is invoice financing?

Invoice financing is a way for businesses to release some of the money tied up in their unpaid invoices

With invoice financing, a finance provider uses these unpaid invoices as security to release an advance payment to the business. The advance is an agreed percentage of the value of the invoices. 

With debt factoring – a specific invoice finance arrangement – it is common for a business to receive around 80% to 85% of the value of factored invoices up front. However, depending on the type of invoice financing arrangement and the specifics of the business, a business can receive as much as 95% of the value of their unpaid invoices as an advance payment. 

The advance is often paid quickly: sometimes within just 24 hours. This is a key advantage of invoice finance and can be very beneficial from a cash-flow perspective. Invoice finance providers will charge various fees for their services, however, which means invoice financing reduces overall profits in the long run. 

There are two main types of invoice financing: invoice factoring (also called debt factoring) and invoice discounting. 

How does invoice financing work?

Debt factoring (or invoice factoring)

Debt factoring (also known as invoice factoring) is a type of invoice financing. 

The way debt factoring works is that a business essentially sells its unpaid invoice debts to a third party – either a dedicated factoring company or a financial services company with a factoring division. In return, the factoring company pays the business a sum of money up front. Exact figures will vary depending on your business and its circumstances, but it is common for these advance payments to be between 80% and 90% of the value of the invoices.

Instead of your customers paying you directly, the factoring company will now collect your customers’ payments on your behalf. Factoring may cover a single invoice (known as spot factoring) or may be an ongoing arrangement, with the factoring company collecting debts from multiple customers over a longer period of time. Spot factoring may also be referred to as Selective Invoice Finance (SIF).

Factoring companies charge a discount fee, known as a factor rate. This may vary from 0.5% to 7% of the total value of the invoices you’re selling and is likely to be charged on a weekly or monthly basis until all outstanding invoices have been paid. Some factoring companies may charge other fees, such as service fees and set-up fees, on top of the factor rate.

When all the outstanding invoices have been paid by your customers, the factoring company will pay you the difference between the value of the invoices and how much they paid you up front, minus fees. Ultimately, your business gets paid quicker, but you will end up receiving less money than if you had simply waited for your customers to pay their invoices.

Debt factoring is generally more popular with smaller businesses, as it is often easier to secure funding from a factoring company than through other means of acquiring finance. 

Invoice discounting

Invoice discounting is very similar to invoice factoring, albeit with one key difference. With invoice discounting, your business does not give up control over collecting customer payments. 

If you use invoice discounting, your business will still be able to essentially borrow money against the value of your unpaid invoices. However, unlike with invoice factoring, the responsibility for collecting your customers’ payments on time still lies with you.

Another difference with invoice factoring is that invoice discounting lenders will not credit check your customers – meaning your customers won’t necessarily know that you are using invoice discounting. 

Invoice discounting is generally more popular with established businesses and businesses with a higher turnover.

What are the advantages of invoice financing?

If your cash flow 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 of the cash owed to you by your customers could mean your business has a more reliable and predictable income. 

If your business uses invoice finance, 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.

Debt factoring, which involves outsourcing your sales ledger, might appeal if you want to free up time spent chasing customer payments to focus on other areas of your business. 

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What are the disadvantages of invoice financing?

Invoice financing services don’t come free. If you enter into an invoice financing arrangement – regardless of whether you use discounting or factoring – the lender’s fees mean you won’t receive the full value of the invoices you’re financing. Additionally, some invoice finance providers may charge a termination fee if you want to end the agreement early.

Also, be aware that much like business loan providers, invoice finance providers will carry out credit checks when you apply. This could affect your credit report.

Depending on your agreement, if your customer doesn’t pay their debts, the invoice finance provider may hold you accountable. This is known as recourse factoring, and most debt factoring arrangements are entered into on a recourse basis. Non-recourse factoring generally incurs higher fees.

If your invoice finance provider collects your customer’s payments directly, your customers will be aware of your arrangement. This may affect your reputation and any relationship you’ve built with your customers. 

Generally, invoice finance isn’t a long-term solution to business cash-flow problems. Consider how you can prepare for the end of your invoice finance agreement in advance to make sure cashflow isn’t an issue for your business once that agreement ends. 

Which type of invoice financing is right for my business?

All types of invoice financing can provide timely access to money your customers owe your business. However, invoice financing can take a few different forms, and it’s important that you make sure the specifics of any invoice finance arrangement are right for your business. 

The key differences between the various forms of invoice finance arrangements have to do with who is responsible for collecting your customers’ payments and whether your customers know about the arrangement.

Debt factoring (or invoice factoring) advantages and disadvantages

Debt factoring is a type of invoice finance which involves the factoring company taking control of the sales ledger operations of the business. This means the factoring company becomes responsible for collecting your customers’ debts on your behalf.

The factoring company pays the business a percentage of the value of each invoice up front. This is called an advance. After paying the advance, which may be as much as 95% of the invoice value, the factoring company collects the money owed by each customer. 

When all outstanding invoices have been paid, the factoring company pays the business the rest of the invoice value, minus their fees. 

Advantages 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.

Disadvantages of invoice factoring

  • 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 no longer being able to deal with you directly. 

Invoice discounting advantages and disadvantages

Invoice discounting is similar to invoice factoring in many ways. With invoice discounting, a business can borrow money against the value of their unpaid invoices at an agreed percentage of the overall value. 

With invoice discounting, the finance provider may advance up to 100% of the invoice value. As with invoice factoring, fees and charges are deducted after all outstanding invoices have been paid. .

The main difference with invoice discounting is that the provider doesn’t manage the business sales ledger or provide debt collection services. This means your business maintains control of issuing reminders and collecting payments. 

Advantages 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.

Disadvantages of invoice discounting

You remain responsible for your sales ledger and credit control.

Selective invoice finance (SIF) advantages and disadvantages

With selective invoice finance (SIF), sometimes known as spot factoring, you choose which specific invoice or customer account you want to finance. SIF is a more flexible option if you’re not looking to outsource your whole sales ledger.

Advantages 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.

Disadvantages of SIF

  • 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.
  • SIF can be harder to secure than other types of invoice financing, especially for small businesses.

How to apply for invoice financing

Your business will usually need to meet certain criteria to access invoice financing. 

Most invoice finance providers will insist on a minimum annual turnover. Invoice finance providers also generally like to see that your business has an established trading history.

Am I eligible for invoice financing?

To be considered for invoice financing, you’ll usually need to:

  • meet minimum turnover requirements
  • be registered with Companies House in the UK or Ireland
  • sell to other businesses (B2B sales) rather than to members of the public (B2C sales)
  • sell on credit terms
  • provide evidence of your trading history

If you fit the criteria and want to apply for invoice finance, make sure you shop around for the best deals. Bear in mind that there are huge variations in the fees and percentages charged by different invoice finance providers. 

You’ll also want to be sure of the quality of service, so take the time to compare different invoice finance providers and look at customer feedback. And make sure you’re clear about the fee structure and terms before you go ahead with any invoice finance agreement.

» COMPARE: Invoice Finance UK – Compare Invoice Finance Rates

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