Sooner or later, every business will have to tackle the question of how to raise capital. Whether to fund operation expansions, purchase equipment, or cover an unexpected cost, a large amount of capital is required. However, it’s unlikely that a company has such a cash reserve on hand, meaning it must be financed externally.
There are many options for businesses to raise capital, each with its own advantages and disadvantages. One such option is invoice financing. In this article, we will break down this form of finance, how it works, and the benefits it can provide.
What is invoice financing?
Invoice financing, alternatively known as accounts receivable financing, is a method of raising capital sourced from the sale of unpaid invoices. The invoices are sold to a third party for up to 85% of its value up front, with the remainder being paid once the third party receives the value of the invoice. Of this remainder, a percentage will be deducted in fees, with the exact value differing between companies. This makes it a form of asset-based financing, as the invoices themselves are collateral.
As invoice financing is a form of asset-based financing, it tends to be easier than other forms of financing to successfully apply for funding. This makes it excellent for businesses with a poor credit rating, as this isn’t necessarily a rejection by default.
How does invoice financing work?
Invoice financing provides businesses with capital in exchange for unpaid invoices. Due to this, a business will receive the majority of each invoice in a lump sum, usually in a very short space of time. Repayment comes in the form of the invoice financing company collecting the value of the invoice, keeping a percentage in fees. This is considerably different from other structured loans with a fixed sum and fixed term of repayment. With such loans, there is a potentially lengthy process of repayment and a high level of interest. Neither are properties shared by invoice financing.
Generally, invoice financing companies will provide up to 85% of an invoice’s value in advance, keeping what remains until the invoice is collected. However, some companies will advance more than the usual 85%, going as far as the full amount minus their fees. Such companies are fairly rare, so be sure to check the terms before signing on to an agreement that advances less than you need.
Once the invoice is paid, the invoice financing company will deduct their fees from the remaining 15% and pay the rest to you. These fees typically amount to roughly 5% of an invoice’s value, with a processing fee claiming 3% and a factoring fee the remaining 2%. While paying to receive your invoice may seem counterintuitive, you are paying for speed and convenience. Invoice financing can alleviate the pressure on a congested cash flow, freeing up capital for urgent use. This can often be worth the price.
Also Read: A Guide to Using Invoice Financing for Small Businesses
The cost of invoice financing
While convenient, invoice financing can be an expensive tool. Let’s consider an example. Assuming you have an invoice with a value of £10,000, you can expect the average financing company to provide 85%, being £8,500, keeping the rest until the invoice is collected.
A processing fee of 3% will be charged, alongside a factor rate. Factor rates are applied each week an invoice goes unpaid, usually amounting to 1% every week. Should your customer take two weeks to pay the invoice, a total of 5% will be taken in fees, amounting to a total of £500. After this deduction, you will receive £1,000 of the remaining £1,500.
Invoice financing can get expensive, especially with late-paying clients. The cost will rise each week, which could quickly make it more of a detriment than a benefit. However, there are cases where a business requires capital at short notice. You will have to determine whether your financial state makes your business one of them.
Advantages of invoice financing
Despite the cost, invoice financing provides businesses with valuable benefits:
- Quick access to capital: Invoice factoring is focused on speed, putting money in your account quickly. Alternative forms of finance can often leave you waiting for several days or even weeks. Invoice financing can meet your needs in as little as 24 hours.
- Reduces strain on your cash flow: A strained cash flow can make it difficult to pay for expansions, taxes, or payroll. Invoice financing eases this problem, making cash trapped in your cash flow available, allowing you to make those necessary payments.
- Easier application process than other loans: The exact terms of the loan agreement depend on the financing company. That said, it is generally an easier loan type to qualify for. As it is a secured loan, with your unpaid invoices being the collateral. Lenders will consider more than just your credit history and income. They will also look to your clients, assessing their payment history. This often means it is easier to apply for than other forms of finance.
Disadvantages of invoice financing
Of course, invoice financing isn’t free of issues. You should consider the following disadvantages before applying:
- It can be expensive if your clients don’t pay on time: If your clients don’t pay on time, you can expect much higher rates and a mounting cost. This can be made even worse if your clients decide not to pay at all. In such an event, you will likely have to pay back the value of the invoice to the lender. In either case, your clients have the capacity to raise the cost.
- Potential damage to client relations: The finance company will be responsible for the collection of unpaid invoices. As such, they can have an impact on how your clients see your business, as the collectors will be perceived as representatives. While most invoice financing companies will tactfully collect on unpaid invoices, it still presents a risk.
- Difficult to make an accurate budget: As a range of flexible variables has an impact on the cost, it can be a challenge to create an accurate budget. The cost is most notably determined by when your clients pay, which is difficult to pin down in most cases.
Conclusion
Despite its flaws, invoice financing is an excellent solution for businesses looking to relieve a strained cash flow. It is a form of finance that provides fast access to capital, with an application process that tends to be quick, simple, and less restrictive than others.
However, invoice financing has considerable downsides. Most notably is the expense, which is significantly influenced by how quickly your clients like to pay. If your clients aren’t known for their timeliness, you might find this more harmful than good, as the costs will mount quickly. Otherwise, you could stand to benefit greatly from this form of finance.