For small businesses, having an effective means of raising finance is essential. The right method can ensure your business is well-stocked, your employees are paid on time, and it can help facilitate growth. Although it is one of the most important priorities for small businesses, it is often difficult to obtain. Many methods of raising capital are expensive, insufficient, or simply require information a young small business does not have.
Invoice financing is one option readily available to small businesses. It raises the capital necessary for business operation and expansion by removing a cash flow bottleneck – unpaid invoices. Every business knows the frustration of waiting on unpaid invoices, but for small businesses, it can be much more impactful. Late invoice payments can have a knock-on effect, making it harder for a small business to operate smoothly on a tight cash flow.
In this article, we will discuss invoice financing for small businesses, break down how it works, and explain what sets it apart from other forms of finance. Let’s get started.
What is invoice financing?
Put simply, invoice financing is a method of finance that leverages unpaid invoices to raise capital. This is done by effectively taking a loan against the unpaid invoices from invoice financing companies. These companies tend to loan roughly 80%-90% of the value of one or more invoices, rather than the full amount. The exact percentage is highly dependent on a few factors, including the value of the invoices, the quantity, and the tendency of late repayments.
The company will then offer a percentage, which will be loaned out to the borrower until the invoice is paid. The invoice financing company will then expect the borrower to collect the relevant invoices, repaying the loan plus fees. If the invoice goes unpaid, you will have to repay the loan out of your own pocket.
There are a couple of ways to do invoice financing. First, a business could decide to do single invoice financing, which is exactly as it sounds. The business would take a loan against an unpaid invoice to a company, usually one of considerable value, and gain a lump sum of capital almost immediately. This can be perfect for plugging a business’s financial gaps, such as making payroll or financing an emergency stock order. This can also be achieved another way, by leveraging several invoices to raise a significant sum of capital. Both ways are viable, though they naturally depend on your business’s situation.
Learn More about invoice financing and how it works here.
Invoice financing vs. invoice factoring for small businesses
A common mistake that businesses make is confusing invoice financing and invoice factoring. While the two terms are often used interchangeably, they are distinct concepts with clear differences. The most notable difference is exactly who collects the unpaid invoices. With invoice financing, the borrower takes out a loan effectively using the unpaid invoices as security, yet they are expected to make the collection. Once the invoice is paid, the borrower will repay the loan, plus fees. With invoice factoring, however, the lender handles the collection.
This constitutes the main difference between invoice financing and invoice factoring. Whereas invoice financing takes a loan against unpaid invoices, invoice factoring essentially sells them to an invoice factoring company. This company then loans out the value of these invoices to the borrower, then collects the invoices on their behalf. While quite convenient, this is a double-edged sword; it takes the burden of chasing unpaid invoices off your shoulders, but can give your customers a poor perception of your business.
Your customers will know that their invoices have been sold to an invoice factoring company, which might make them think your business is experiencing financial difficulties. Alternatively, your customers may not like how the invoice factoring company handles the collection. As they are essentially collecting on behalf of your business, this may reflect poorly. Neither of these points are a concern for invoice financing, as your customers won’t know that you have contacted an invoice financing company.
Another key difference between the two methods is price. Invoice factoring is considerably more expensive than invoice financing. Owing to the fact that the invoice factoring company must collect the invoices themselves. This is reflected in the fees, which can make it impractical for businesses operating on a particularly tight cash flow. You will have to consider your own situation, weighing up the convenience of not collecting invoices against the higher price.
Also Read: What Is Alternative Finance & How It Can Be Used?
One common thread between invoice financing and invoice factoring is ease of access. As you are either directly selling your invoices, or are taking out a loan against them, the invoices act as security. This means that the application process is not nearly as convoluted as other, traditional forms of finance. Credit history is not as important here, as it has no impact on whether your customers will pay their invoices. As such, it is a great alternative to other forms of finance that require strong credit history and other forms of in-depth information.
What is more important is the information about your customers. While your credit history is not much of an issue, a poor credit history for your customers is much more important. Bad credit on the part of your customers implies additional risk, as does repeated late repayments and other information. While higher risk doesn’t necessarily mean you won’t be able to get invoice financing or factoring, it does increase the risks, and, therefore, the costs.
Conclusion
Invoice financing is perfect for small businesses that have considerable amounts of money tied up in their cash flow. It can help release these funds for immediate use, allowing businesses to fund expansion projects, stock orders, or payroll. Compared to other forms of finance, invoice financing is also relatively cheap, with fewer fees associated. However, the cheapest option is not always the best. Invoice factoring, while more expensive, can sometimes be the better option for a small business, as it allows business owners to focus on the most important aspect – running their business.