Invoice finance is often misunderstood, but once you get past the technical terminology it’s actually quite a straightforward product. The simplest way to describe invoice finance is that it uses your sales invoices as security for a loan, or in some cases a revolving series of loans. Let’s look at how invoice finance works in practice.
How does it work?
Invoice finance is aimed at companies that receive payment by invoicing other businesses for finished projects or delivered goods. Most of the time, invoices have a payment term, after which you’ll get paid. During this period, outstanding money is owed to your business.
With invoice finance, this delay is mostly transferred onto the lender, unlocking the money early for you but still allowing your customers to pay you on terms. Here’s how it works:
- After work is completed, you raise an invoice
- Invoice goes to both customer and lender
- Percentage of invoice value (up to 90%) advanced to you
- Payment terms pass as normal
- Invoice paid by customer
- You get remainder of invoice value (i.e. 10% in this case) minus lender’s fees
Why invoice finance?
Invoice finance’s main benefit is that it mostly removes the issue of payment terms for you, while leaving your customers payment schedule unaffected. They can still pay you after the agreed time, which can be as long as 120 days in some sectors, but you receive most of the owed money as soon as the invoice is raised.
This enables you to better manage cashflow — you get most of the money more or less up front instead of waiting weeks for it to hit your account. Certain products such as invoice factoring also have the added benefit of credit control, which I’ll explain below.
Particularly if you have big clients or large invoice amounts, getting the extra working capital early means you can carry on with the next project, pay for growth strategies, or simply know you can meet your own payment obligations on time.
Types of invoice finance
Invoice discounting works as I have described — you simply send an invoice to the lender and they’ll advance most of the cash immediately. Most discounting facilities are confidential, so your customers won’t know you’re using a finance provider.
However, because the lender has little hands-on involvement, the creditworthiness of your customers matters more, and so discounting can be hard to secure for smaller businesses. For this reason, discounting is most often used by bigger companies with large sales ledgers and creditworthy clients, but when secured, is usually cheaper than factoring.
As I mentioned above, invoice factoring includes credit control, which is very useful for businesses that have suffered from late payment. Credit control means the lender deals directly with your customers and handles the administrative side of managing debtors — which includes payment reminders when due dates are near, and even legal action if necessary. Of course, this means that unlike discounting, invoice factoring isn’t confidential and your customers will know you’re using finance.
These credit control services make factoring more expensive than discounting most of the time, because the lender takes an active day-to-day role in dealing with your customers. Having said that, it’s by no means seen as a disadvantage by the smaller businesses that tend to use it — because it frees them from administrative tasks and worrying about late payments, and allows them to focus on important business activities.
Also, smaller businesses are less likely to have credit controllers or financial directors, so credit control can be seen as an additional service included with the finance package. Some businesses will still prefer managing their own debtors, though.
Selective invoice finance
There is also a range of more flexible invoice finance types, which go by a variety of names including selective invoice finance and spot factoring. What they have in common is they allow you to fund specific individual invoices or client accounts, which is handy if you want to finance invoices from a big client but continue as normal with the smaller due payments.
Selective invoice finance and spot factoring both depend largely on the creditworthiness of your customers, so having big companies on your books will make it easier to secure.
By Conrad Ford, chief executive of Funding Options