Invoice Financing: Definition, Types, Pros & Cons

Invoice Financing
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Invoice finance allows companies to borrow money against sums owed to them by customers. With this method, businesses around the globe are able to improve cash flow, pay staff and suppliers, and reinvest in operations and growth sooner than they could if they had to wait for their customers to pay their accounts in full. But then, as a fee for obtaining these funds, businesses often have to pay a percentage of the invoice amount to the lender. In other words, invoice financing solves the issue with customers who take a long time to pay, as well as difficulty acquiring other types of business credit. Now the question is, how do you go about this? What are your options when it comes to this type of business financing? What are the types of Invoice financing?

Well, grab a seat as we go through the fundamentals of invoice financing.

What Is Invoice Financing?

Invoice finance is an alternative term for Accounts Receivable Financing. It is a type of asset-based financing in which a company receives a cash advance in exchange for unpaid invoices. Invoice financing firms can literally advance you up to 85% of the amount of your bills, with the remaining 15% (minus costs) due when your invoices come in.

Invoice financing is easier to qualify for than other types of small business loans. This is because the invoices themselves act as collateral for the funds you want to borrow. Over the years, it has been pegged as one of the best funding options for B2B and service-based firms; largely because it helps to solve cash flow issues that come with tardy client bills.

How does Invoice Financing Work?

Oftentimes, businesses have to sell goods or services on credit to large consumers, such as wholesalers or retailers. This means that the buyer is not expected to pay for these products right away. An invoice with the total amount owing and the bill’s due date is sent to the purchasing firm.

Unfortunately, this practice locks up funds that could otherwise be used to develop or expand a company’s activities. Businesses may choose to finance their invoices which will, in turn, finance slow-paying accounts receivables or fulfill short-term liquidity needs.

Invoice finance is a short-term credit provided by a lender to its company customers in exchange for outstanding bills. A company sells its accounts receivable to increase its working capital through invoice factoring, which provides the company with quick funds that may be utilized to pay for corporate expenses.

Invoice Financing From the Lender’s Perspective

Unlike issuing a line of credit, which may be unsecured and provide little recourse if the business does not repay what it borrows, invoice financing provides lenders with collateral in the form of invoices. The lender further reduces its risk by not advancing the whole amount of the invoice to the borrower. However, because the customer may never pay the invoice, invoice financing does not eliminate all risks. This would result in a time-consuming and costly collection action involving both the bank and the company that used the bank for invoice financing.

Structure of Invoice Financing

Invoice financing can take a variety of forms, the most prevalent of which being factoring and discounting. When a firm uses invoice factoring, it sells its outstanding invoices to a lender, who may pay the company 70 percent to 85 percent of the invoices’ final value upfront. If the lender receives full payment for the invoices, it will send the remaining 15% to 30% of the invoice amounts to the firm, with the latter paying interest and/or fees for the service. Customers, however, need to be aware of this arrangement because the lender receives payments from them, which may reflect adversely on the firm.

Read Also: Invoice Factoring: All You Need, Explained!! (+ Loan Options)

On the flip side, a firm could also utilize invoice discounting, which is similar to invoice factoring. However, unlike the latter, the business collects payments from customers rather than the lender with the customers totally in the dark. The lender will advance the business up to 95% of the invoice amount using invoice discounting. The firm repays the lender, less a fee or interest when customers pay their invoices.

Read Also: Invoice Discounting: Explained!! (+ Quick tools & amp; all you need)

What Is the Cost of Invoice Financing?

The projected annual percentage rate (APR) for invoice finance might range from 10% to 60%. To give you a clearer idea of how costly invoice financing might be, consider the following scenario:

Let’s imagine you have a $100,000 invoice with a 30-day payment deadline.

You discover a lender ready to advance you 85 percent of the total—$85,000—while keeping the remaining $15,000 in reserve.

The corporation will impose a 1% factor rate plus a 3% processing fee for each week the customer takes to pay the invoice. Because the customer takes two weeks to pay the invoice in this situation, you’ll have to pay 2% in factoring fees ($2,000) plus a 3% processing fee ($3,000).

Consequently, you’ll only get $10,000 ($15,000 – $5,000 in fees) out of the $15,000 held in reserve by the financing business. Overall, invoice financing would have cost you $5,000 of the original invoice amount or a 70 percent annual percentage rate.

That may appear to be a high fee to pay, but in the end, it comes down to your company’s financials and whether that amount is worth having early access to your cash.

Invoice Financing Types

Invoice factoring and accounts receivable lines of credit are the two major types.

Factoring invoices

Although invoice factoring and invoice finance are frequently used interchangeably, there are several distinctions between the two types of financing.

You repay the advance of funds you borrowed, plus fees when it comes to financing invoices. On the other hand, you actually sell your invoices to the invoice factoring company at a discount when you use invoice factoring.

In most circumstances, this also necessitates the invoice factoring company collecting money from your clients.

Line of Credit for Accounts Receivables

An accounts receivable line of credit is a type of invoice financing in which you finance a credit line using your outstanding invoices. The line of credit is secured by your invoices in this situation. Plus the amount you receive on the line is often up to 85 percent of the invoice value.

An accounts receivable line of credit, unlike traditional invoice financing or invoice factoring, which gives you a full advance on the value of your bills, allows you to draw funds as needed—just like any other business line of credit.

You pay an interest rate based on your balance on an accounts receivable line of credit. And when a client pays their invoice, the amount goes off your current balance. Furthermore, some lenders may charge you a draw fee each time you use your credit card.

In most circumstances, an accounts receivable line of credit (as opposed to factoring) is similar to regular invoice financing in that you retain ownership of your invoices and are responsible for collecting customer payments.

Invoice Financing Services

It’s similar to factoring, but it’s not a sale of your receivables. Invoice finance works by utilizing your accounts receivables as collateral to acquire a loan, but you’re still in charge of collecting payments. You will be liable for the amount you were advanced if your customers’ payments fall behind. The monthly fees are typically 2-4 percent of your invoice amount.

The Benefits and Drawbacks of Invoice Financing

Of course, invoice finance isn’t perfect for every business, just like any other sort of funding. First and foremost, because of the nature of this type of business financing, it is best suited for B2B and service-based businesses. It is also a frequent funding option for those in retail, manufacturing, healthcare, real estate, and consulting.

If you’re attempting to evaluate if invoice financing makes sense for your small business, you can reference the advantages and cons below:

Pros

#1. Quick access to working capital:

Because invoice financing is secured by your accounts receivable, it is often funded quickly, especially when working with alternative lenders who provide their services online. You may be able to get money in as short as a day.

#2. Reduces cash flow issues induced by outstanding invoices:

If you’re short on funds to cover upcoming expenses such as taxes or payroll, invoice financing allows you to free up cash flow to cover those costs.

#3. Easier to qualify for than other types of business financing: 

Although the conditions for invoice financing vary depending on the lender, you’ll find that because the financing is secured by your invoices, they will be considerably more flexible with prerequisites. Lenders will look at your clients and their payment history, rather than just your credit score and financials.

#4. Invoices serve as collateral:

As previously said, your invoices act as collateral with this financing. This not only makes it easier to qualify for them but also makes it more likely that you won’t need to put up other assets like real estate or inventory as collateral.

#5. Low cost if your customers pay on time:

While invoice financing is more expensive than other types of business loans, it’s a different ball game if your customers pay on time, if not early. When you take out a standard loan, you’ll pay interest for the full period, but with invoice financing, you’ll only pay fees as long as the invoice is open.

Cons

#1. Fees may be higher than other types of financing:

Invoice finance can be reasonable in some ways, but the fees you end up paying are sometimes higher than those charged by other types of loans. Furthermore, depending on the lender, you may be required to satisfy monthly minimums or pay additional fees.

#2. Cost is difficult to estimate upfront:

Although an invoice finance calculator can help you predict costs to some extent, determining exactly how much invoice financing costs ahead of time is challenging. The total cost of this financing will vary because the final costs you pay are dependent on how long it takes your customer to pay.

#3. If clients pay late or don’t pay at all, it can be costly and risky:

When it comes down to it, if your customers are late with their payments, this form of financing will be extremely costly. Some lenders levy significant late fees or raise interest rates for each week a customer fails to pay. If your consumer doesn’t pay at all, on the other hand, you’ll normally be liable for repaying the lender in full, which could be problematic for your cash flow.

#4. For most B2C enterprises, this isn’t a viable option:

Finally, as previously said, accounts receivable financing is highly specific. In order to apply for invoice financing, you must have outstanding bills. As a result, if you run a B2C or subscription-based firm, this funding is unlikely to be a choice for you.

Invoice Financing FAQs

Is invoice financing a good idea?

Invoice Financing is, of course, a good idea for small and large business corporations. However, there are exceptions. For B2B and service-based businesses, this is totally a bad idea.

What is the difference between invoice finance and factoring?

The primary difference between invoice factoring and invoice financing is who collects on the outstanding invoices of the company. The consumer retains complete control over collections while using invoice financing. Invoice factoring is when a company buys unpaid invoices and takes over the collection process.

How much does factoring invoices cost?

The corporation will impose a 1% factor rate plus a 3% processing fee for each week the customer takes to pay the invoice. Because the customer takes two weeks to pay the invoice in this situation, you’ll have to pay 2% in factoring fees ($2,000) plus a 3% processing fee ($3,000).

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