If you’re considering using invoice finance, read our guide to understand how his type of funding could work for your business.
Resolving cashflow problems can be a hurdle for any size or type of business, not least where a business works with other businesses on deferred payment terms. This is because extending credit terms, even for short periods of time, can impact the available money that a business has to discharge its own debts, from paying suppliers to paying its staff.
In addition to meeting its own financial obligations, a business may also need to raise working capital to expand its operations where, in either scenario, from reducing debt to facilitating growth, invoice finance can provide a business with the ideal short-term financing solution.
In this guide, we look at the two main forms of invoice finance: invoice factoring and invoice discounting. We explain what these are and how they both work in practice. We also look at the pros and cons, the potential costs involved and how they differ to each other.
What is invoice finance?
Invoice finance is a form of short-term financing designed for businesses that trade with other businesses on credit terms. This is where there is typically a gap between sending an invoice and when the customer settles that invoice, usually between 30 to 120 days.
There are two main forms of invoice finance: invoice factoring and invoice discounting. As accounts receivable finance, where accounts receivable refers to the balance of money owed to the business, these two types of invoice finance both enable a business to recoup early payment on some or all of its outstanding invoices in return for a fee. In invoice factoring, the business effectively ‘sells’ outstanding invoices to a third party finance provider at a slight discount. In contrast, in invoice discounting, the finance provider ‘loans’ the business money, and on which it pays interest, where the unpaid invoices act as collateral.
In either case, the invoice finance company will immediately advance the bulk of the value of each invoice upfront, providing a business with an easy way to get paid more quickly on some or all of its invoices. As such, invoice finance has become a popular alternative to more conventional short-term financing options, especially for those businesses who do not qualify for traditional-style loans or overdraft facilities, perhaps due to imperfect credit, a short trading history or any other challenging circumstances. Invoice finance can also be ideal for any business looking for a flexible way to finance new growth opportunities.
How does invoice finance work?
Invoice finance works in slightly different ways, depending on whether a business has opted for a factoring or discounting facility. With invoice factoring, the factor will ‘buy’ approved invoices, making available an agreed percentage of the value of an invoice for the business to draw down, with the balance to be paid once the customer settles the invoice in full, albeit minus the factoring fee. With invoice discounting, the discounter will again advance an agreed percentage of the value of an invoice to the business, but by way of a loan, with this to be repaid, together with interest, once the customer discharges their debt.
In invoice factoring, the factor will take responsibility for chasing, collecting and processing invoice payments, buying invoices at a discount and then collecting payments from customers based on the full value of those invoices. In the context of invoice discounting, control of its accounts receivable remains entirely with the business.
The invoice factoring process can be broken down into the following steps:
- The business will provide goods and/or services to its customers as normal
- The business will invoice its customers for those goods and/or services
- The business will ‘sell’ the raised invoices to a factoring company
- The factor will advance the business the bulk of the invoiced amount, usually within 24 hours and typically up to 90% of the value, after verifying the invoices are valid
- The customer will pay the factor directly, with the factoring company chasing payments and liaising with these customers, if needed
- The factor will forward the remaining invoice amount to the business, minus a pre-agreed factoring fee, once the customer has settled an invoice in full.
For example, having experienced cashflow problems, Joe Blogg’s Business agrees to a factoring arrangement with Anytime Finance Ltd based on an immediate advance of 85% of any invoice value. As such, when Joe raises an invoice worth £5,000 and uploads this online, Anytime Finance will advance Joe Blogg’s the sum of £4,250. Once the customer has paid Anytime Finance the full £5,000, Joe Boggs will be forwarded the remaining balance of the invoice, but with Anytime Finance’s fee deducted. In this example, let’s say that Joe Blogg’s Business was liable to pay £250 in fees for the use of the factoring facility, the business would receive a further sum of £500 once the invoice had been fully paid.
The invoice discounting process can be broken down into the following steps:
- The business will provide goods and/or services to its customers as normal
- The business will invoice its customers for those goods and/or servicesThe business will forward the raised invoices to a discounting company as proof of what it is owed, in this way using the invoice as short-term security for an advance payment
- The discounter will evaluate the invoice and agree to advance a percentage of its value as a short-term loan, often within 24 hours and typically up to 95% of the invoice total
- The customer will settle the invoice, at which stage the business will be required to repay the loan, with interest, although some discounting arrangements may require customers to pay into a trust account in the name of the business but controlled by the discounter.
For example, when looking to raise capital to expand its operations, Joe Blogg’s Business agrees to a discounting arrangement with Anytime Finance Ltd based on an immediate advance of 95% of any invoice value. As such, when Joe raises an invoice worth £5,000 and uploads this online, Anytime Finance will advance Joe Blogg’s the sum of £4,750. Once the customer has settled the invoice in full, and assuming this is paid directly to Joe Bloggs, Joe will be required to return the loan amount of £4,750, together with interest. In this example, let’s say that Joe Blogg’s Business was liable to pay £125 in interest for the use of the discounting facility, he would need to return a total payment of £4,875 at this stage.
Pros & cons of invoice finance
There are various pros when it comes to invoice finance arrangements, not least the fact that a business will benefit from receiving the bulk of an unpaid invoice without having to wait for the customer to settle that invoice. In this way, invoice financing will resolve any immediate cashflow problems or provide a way for a business to raise working capital.
Invoice financing will also provide a relatively cost effective financing solution to those businesses who are unable to secure more traditional forms of finance, perhaps because a business has imperfect credit, a short trading history or other challenging circumstances. Although there will be either a fee or interest payable on any cash advance made to the business, these fees are usually only payable on the amount drawn down. The fees and interest can also be adjusted, depending on any changing circumstances of the business.
However, there are also various downsides to invoice financing, although the drawbacks will depend on the type of invoice finance used. For example, with a factoring facility, as the factor will take responsibility for credit control, this arrangement will not usually be confidential. This means that customers will become aware that a business is using a finance provider which, in turn, could create a bad impression and negatively impact future working relationships, especially if any customer service experience is poor. That said, any concerns over customer perceptions can be allayed by opting for a factor that is able to offer excellent customer service, effectively providing an extension of the business brand. By chasing and collecting payments, the factor will also free up valuable time and resources for the business that can be better invested in other areas, such as expansion.
When it comes to invoice discounting, although it does not offer the same credit control services, this type of arrangement tends to be much cheaper than invoice factoring because of this. These arrangements are also confidential. As the business retains responsibility of its own sales ledger and debtor book, a customer would not be privy to knowledge of any relationship between the discounter and the business. However, discounting facilities are more difficult to obtain, as this type of arrangement can be far riskier to a lender who is not responsible for credit control. As such, discounting is usually aimed at well-established businesses with a sizeable turnover and a strong credit collection department.
In respect of both invoice factoring and invoice discounting, depending on the nature of the arrangement, the business will also usually be liable for any bad debt. This essentially means that if a customer fails to pay an invoice in full, the business will be responsible for repaying any cash advance. In some cases, the invoice finance provider may agree to provide what is known as non-recourse financing, where the finance company absorbs any bad debt. However, even if this is available, this will come at significant additional cost.
How much does invoice financing cost?
The cost of invoice finance can vary significantly, depending on the finance provider, as well as the size and nature of the business looking for finance approval. There are a wide range of invoice finance providers across the UK, including major banks, large independent providers, small local providers and even niche sector specialists. The cost of invoice finance to a business can also depend on things like the age and turnover of the business, the creditworthiness and reliability of its customers, the value of invoices to be financed, the percentage of any advance on the value of those invoices and invoice payment terms.
With invoice factoring, the overall fee structure will usually comprise a number of different charges, including a set-up fee, a discount fee calculated against the balance of the funds drawn, and a service fee to cover the cost of things like credit checks and customer communications. Although invoice discounting can also include a set-up and service fee, it will apply interest on the cash advance used by the business, rather than a discount fee.
However, both the discount fee in invoice factoring and interest charged for invoice discounting will operate in a very similar way to interest rates on a bank loan, to be applied on either a daily, weekly or monthly basis. It is this rate that will usually be determined by things like the overall risk profile of the business and its customers. Generally speaking, the lower the risk to the invoice finance provider and the greater the overall value of the invoices to be financed under the facility, the lower the overall charges. Conversely, the higher the risk and lower the invoice total, the higher the finance charges.
Differences between invoice finance, factoring and discounting
Both invoice factoring and invoice discounting are forms of invoice finance, each able to offer a business a short-term finance solution for addressing any cashflow problems or raising working capital. However, even though they are both forms of invoice financing, there are critical differences between the two, the main ones being visibility and control.
However, for those businesses with a short trading history or low turnover, invoice factoring may be the only form of invoice finance available to them at the present time. In invoice factoring, where the factor has overall control of recouping the debt and ensuring that customers pay their invoices on time, factoring is lower-risk from the provider’s perspective. As such, acceptance for a factoring facility is virtually guaranteed because of this.
It is only by understanding these key differences that an informed choice can be made as to the best option for a business when it comes to short-term financing, given the potential pros and cons involved based on its individual circumstances. Equally, for a business limited to invoice factoring, perhaps due to its young age and current turnover, invoice discounting may be an option to consider later down the line when the business is more established.
Invoice finance FAQs
How does invoice financing work?
With invoice finance, the third-party provider agrees to advance a percentage of the value of an approved invoice for the business to draw down. Also known as accounts receivable financing, this is based on the money owed to a business.
What are the benefits of invoice finance?
There are various benefits to invoice finance, not least the fact that a business will get paid on the bulk of outstanding invoices much quicker than waiting for customers on deferred payment terms to settle their invoices in full.
How do invoice financers make money?
An invoice finance company will charge either a pre-agreed fee or interest for advancing payment to a business based on the value of outstanding invoices, although the way in which this works varies as between invoice factoring or discounting facilities.
Is invoice finance regulated in the UK?
Invoice finance is not currently regulated by the Financial Conduct Authority (FCA) in the UK, as there would be significant costs associated with FCA regulation. As it stands, therefore, invoice finance providers are self-regulated.
The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal or financial advice, nor is it a complete or authoritative statement of the law or tax rules and should not be treated as such.
Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission.
Before acting on any of the information contained herein, expert professional advice should be sought.