As a small business owner, it can be difficult to ensure a regular line of working capital needed to pay bills and support operations growth. This difficulty is especially apparent if the company is new.
To reduce cash flow fluctuations, companies will frequently consider various financing options. One of the most common financing tools that new businesses use to quickly generate cash is invoice financing.
What Is Invoice Financing?
If you are seeking to finance your invoices to obtain much-needed cash, invoice financing may be a good option. An invoice financing loan allows companies to borrow against accounts receivable invoices issued to their customers.
A small business will work with a lender to provide invoices as collateral in exchange for access to immediate cash. The cash allows the company to pay current bills due, such as payroll or regular suppliers. It can also be used to reinvest in operations.
In exchange for cash, the company will pay the lender a percentage of the invoices. Utilizing invoice financing can help businesses collect monies from slow-paying clients. It is usually much easier for a business to obtain invoice financing than a traditional bank loan.
How Does Invoice Financing Work?
There are several steps a company must follow to obtain an advance on outstanding invoices.
First, an invoice is generated when goods or services are provided to a customer. The details of the invoice are then sent to the invoice financing lender. Once the lender has reviewed the invoice, they will send a percentage of the invoice to the business within a defined period of time, usually less than 48 hours.
Depending on what type of invoice financing agreement you have entered into, your business or the lender will work with the customer to secure payment. Once full payment of the invoice is received, the lender will send you the remaining value of the invoice, less a percentage for the financing service.
Why Do Lenders Offer Invoice Financing?
Invoice lending is advantageous to banks because the money that they supply to a business is backed by the collateral of the invoice. There is still some risk involved in invoice financing, but it is limited to whether a customer will pay.
To mitigate the risk, banks can review customer payment history prior to agreeing to a financing arrangement. Lenders who offer invoice financing do so with higher interest rates and fees than a traditional bank loan would offer.
How Is an Invoice-Based Loan Structured?
Invoice-based loans are structured according to the type of financing agreement that a business enters into. There are three common types of invoice finance options. These include the following:
Invoice factoring is common in industries such as clothing and manufacturing, where long accounts receivable are part of the normal business cycle. In a factoring arrangement, a lender will purchase an outstanding invoice and advance the business a set amount of money based on the customer’s risk profile.
The amount advanced varies but typically amounts to 50% to 80% of an invoice’s value. The lender assumes the responsibility of collecting the amount due from the customer.
Once it is received, the lender issues the business the remaining value of the invoice, less a fee for the service. The fee will vary but is normally between 3% and 5% of the total value of the invoice.
Under an invoice financing arrangement, a lender agrees to fund a business with a specific amount based on the overall value of their accounts receivable. This approach is similar to factoring, but the business remains responsible for collecting receivables from its customers.
Invoice financing is generally a bit cheaper than invoice factoring. Fees vary from 2% to 4% of the total value of accounts receivable financed.
Receivable-Based Line of Credit
A receivable-based line of credit is established between a business and a lender. The value of the credit line is usually between 80% and 85% of the value of total accounts receivable.
As payments for invoices are collected, the balance owed by the business is reduced. The company retains the right to collect invoices from its customers. In this arrangement, fees are usually less than those that are available under invoice factoring or invoice financing arrangements.
Pros of Invoice Financing
As with all types of financing, invoice financing has advantages and disadvantages. The pros of invoice financing include:
Fast Access to Cash
Entering into an invoice financing arrangement can provide your company with very quick access to working capital. This access can reduce the risk of missing important payments such as payroll or supplier invoices. Funding is usually provided within 48 hours.
Alleviates Cash Flow Problems Due to Slow-Paying Customers
It can be extremely frustrating to wait on payments from customers who are slow to pay, especially if they make up a large part of your company's accounts receivable balance. Invoice financing can provide a sense of regularity to the collections process and reduce problems caused by late-paying customers.
Easier to Qualify for than a Loan
This ease of access is especially important for small businesses that haven’t been open long enough to generate credit or that have financial problems. Invoice financing doesn’t require a credit check on the business or its owners. Instead, financing is granted based on the value of the invoices and the customer’s history of payment.
Low Cost if Payment from Customers Received on Time
If you have customers who pay their bills on time, the cost of invoice financing will be relatively low. There will be no need for excess efforts by the lender or your company to collect payments due from a customer on your behalf.
Optimal for B2B or Seasonal Companies
Invoice financing is most appropriate for businesses that sell to other companies or for those who operate in seasonal industries. It is generally very easy for these types of businesses to qualify for invoice financing.
Cons of Invoice Financing
There are a few cons associated with invoice-based financing. These include:
Can Be Very Expensive
While the upfront fees may appear small, costs associated with invoice financing can be quite expensive.
Lenders typically charge a percentage of the invoice each week until it is paid. Fees may range from 1% to 5%. If a company is very slow to pay, the overall value of the invoice can be significantly reduced. It is not uncommon to see fees as high as 50% due to slow-paying customers.
Difficult to Evaluate Upfront Costs
Since the cost of invoice financing is determined by the length of time it takes a customer to pay, it can be difficult to conclude how much it will cost.
Not an Option for B2C Businesses
Since businesses that sell to consumers typically collect payment at the point of sale, invoice financing is usually not available to them. These types of companies will need to consider other types of financing if they encounter cash flow difficulties.
How to Know if Invoice Financing Is Right for Your Business
Deciding whether invoice financing is right for your business requires a lot of consideration. It is important to have a clear understanding of your customers' paying habits and of lenders’ invoice financing agreements.
You should have an awareness of how much invoice financing will cost your business and if it will impact relationships with your customers.