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When businesses sell products or services, they often extend credit to customers such as retailers or wholesalers. Companies cannot access the funds they are owed until customers pay their invoices, which can lead to cash flow problems. Companies can use invoice financing to receive an advance of capital based on their unpaid invoices.
What is invoice financing?
Invoice financing (also known as accounts receivable financing) is a type of short-term loan that allows businesses to borrow money against their unpaid invoices. The unpaid invoices serve as collateral, and once the invoices are paid off, you can pay back the loan, minus any fees owed to the lender.
It’s common for companies, especially business-to-business companies or service providers, to allow customers to buy products or services on credit. This means that there is a period of time during which the company can expect to be paid a certain amount of money but cannot access it until the customer pays the bill.
When customers take a long time to pay their bills, businesses are unable to access those funds, which can cause cash flow issues. Invoice financing can provide funds that businesses can use immediately for working capital, payroll, supplier payment, expanding operations, investment, or other necessary payments.
- You have a large rent bill coming up, and your business is low on cash. However, you have an outstanding invoice worth $50,000 with a customer who reliably pays on the due date, which is in 60 days. You take out invoice financing on this unpaid invoice, and the lender loans you $42,500 (or 85% of the invoice value), using the unpaid invoice as collateral. Once your customer has paid the invoice, you can pay back the loan, with the lender taking $3,000 (or 3%) as a fee.
Invoice financing is often easier and faster to qualify for than traditional business loans because the invoices serve as collateral for the loan. However, invoice financing can end up being quite expensive if customers are late to pay or don’t end up paying at all.
How does invoice financing work?
What is invoice discounting?
Invoice discounting is the traditional form of invoice financing and you may see it referred to simply as invoice financing or accounts receivable financing. Invoice discounting is a type of revolving loan that is secured by your accounts receivable.
When you use invoice discounting, your lender gives you an advance payment of capital based on the amount of revenue expected from your unpaid invoices. The lender will take a percentage as its fee. The unpaid invoices act as collateral for the loan. This means that invoice financing is less risky for lenders, as compared to other types of financing such as an unsecured line of credit.
Lenders typically allow borrowers to finance up to 85 percent of the value of unpaid invoices, with the lender returning the remaining 15 percent, minus fees, after the invoices are paid. Lenders may also charge a factor rate for each week the invoices are unpaid, plus a processing fee. The borrower is responsible for collecting invoice payment from customers, and once payment is collected, the borrower will pay back the lender.
- You have an outstanding invoice for $100,000. You have immediate cash needs, so you take out a loan through invoice financing, and the lender advances you 85% ($85,000) of the outstanding invoice, with a fee of 3%. A month later, your customer pays the outstanding invoice in full. You pay back the lender the $85,000 borrowed, and the lender returns $12,000 to you, which is the remaining $15,000 minus the 3% (or $3,000) fee.
Invoice Discounting Example
|Initial Advance (85%)||$85,000|
|Remaining Advance (12%)||$12,000|
What is an accounts receivable line of credit?
An accounts receivable line of credit is similar to invoice discounting, but it works slightly differently. While invoice discounting provides you with a loan amount based on the total value of your unpaid invoices, an accounts receivable line of credit allows you to withdraw only the amount of capital that you need, which could be a smaller fraction of the value of your unpaid invoices.
An accounts receivable line of credit works in the same way as other business lines of credit, with your unpaid invoices acting as collateral. You will pay interest on the amount of funds you have withdrawn, and lenders will likely charge a fee each time you withdraw funds as well.
As with invoice financing, you still own your invoices and your customers will pay you directly. The benefit of an accounts receivable line of credit is that you can withdraw smaller amounts of money, which would lower the amount of interest you are charged.
What is invoice factoring?
With invoice factoring, you sell your business’s unpaid invoices to a factoring company for a percentage of the invoices’ value. The lender then provides funds equal to a portion of the value of the invoices (typically up to 85 percent), with the remaining amount paid to the borrower after payment is collected, minus the lender’s fees.
The lender is now responsible for collecting the payment from the borrower’s customers. This can relieve you from the necessity of chasing customers for payment, but it’s important to be aware that this can give a negative impression of your business as customers may feel that you are financially unstable, and there is also a risk that they will have a bad experience with the factoring company.
Note that your business may be ineligible for invoice factoring if your clients are not financially strong, as the invoice factoring company may not believe the invoices will be paid. Businesses should also be aware that factoring companies may charge a number of fees, from collection fees to processing fees to service fees, so it’s critical to carefully evaluate the lender’s terms before proceeding.
- You have an outstanding invoice for $100,000. You have immediate cash needs so you sell this unpaid invoice to an invoice factoring company. The factoring company advances you 85% ($85,000) of the outstanding invoice and will charge you a monthly factoring fee of 2%. Two months later, the customer pays the factoring company the outstanding invoice in full. The factoring company returns $10,000 to you, which is the remaining $15,000 minus the 2% factoring fee for two months (or $4,000) and a 1% processing fee (or $1,000).
Invoice Factoring Example
|Initial Advance (85%)||$85,000|
|Factoring Fee (2% monthly)||$4,000|
|Processing Fee (1%)||$1,000|
|Remaining Advance (12%)||$10,000|
What businesses should consider invoice financing?
Invoice financing can be a good solution for your business, depending on a number of circumstances. You may find invoice financing helpful if your business has:
- Seasonal revenue
- Large invoices
- Long billing cycles
- Established clients with good payment history
Small businesses, in particular, may have limited funds available, meaning that money tied up in unpaid invoices can have a major impact on cash flow. If you’re in need of funds while waiting for outstanding invoices, invoice financing can often provide funding within days, allowing your business to put that money to work quickly, helping you cope with any temporary cash crunch.
What are the advantages of invoice financing?
Invoice financing has several advantages:
- Get through temporary cash crunches. If you urgently need cash to deal with expenses, invoice financing can provide the necessary funds.
- Receive funds quickly. Invoice financing has a quick application and approval process. Funds will typically reach your account within days.
- Additional collateral is not required. The invoices themselves act as collateral.
- Easy qualification. Compared to other loans, invoice financing has less strict requirements for qualification.
- It’s not expensive as long as your customers reliably pay their invoices. Invoice financing becomes more expensive over longer periods of time. If you know that you can expect your customers to pay you promptly, then you can be assured that your invoice financing will be relatively low-cost.
What are the disadvantages of invoice financing?
Invoice financing has a number of disadvantages:
- It’s not suitable for all businesses. Invoice financing is most suitable for business-to-business companies and service providers, as these types of businesses are likely to have unpaid invoices that can be financed. Business-to-consumer companies will likely receive most payments via cash or credit card—this type of payment cannot be financed.
- Higher fees than other loans. Invoice financing usually charges a factor rate, which is a percentage of the total value of the invoices, for each week the invoices remain unpaid. There is usually a processing fee as well. These fees can become costly, especially if it takes a longer period of time before your customers pay their invoices.
- Risk that your customers might pay late or fail to pay their invoices. If customers pay late, your fees could become very high. If you have used invoice financing, you would still be responsible for paying back your loan if your customers fail to pay. In most cases, invoice factoring companies become responsible for collecting payment once they purchase your invoices, but in some cases, you could still be responsible if the factoring company is unable to collect.
- Costs can be unpredictable. Because fees are charged each week until your customers pay, it can be hard to predict how much you will end up paying. If your customers pay their accounts quickly, the cost for invoice financing would end up being lower, while the cost would be much higher if the customers pay at the last minute.
- Invoices cannot be used as collateral for other loans once they’ve been used for invoice financing. If you’re planning to apply for other loans, you may want to use invoices as collateral.
How can you qualify for invoice financing?
Invoice financing is generally not difficult to qualify for, as long as your company has unpaid invoices available. Requirements can vary depending on the lender, and lenders will typically need to evaluate the repayment history and financial strength of your customers as well. The invoice financing application process is generally fast.
In addition, as with other loans, lenders will likely consider your credit scores, financial history, and length of time in business; although these factors are not as heavily weighted with invoice financing as with other types of loan, you may be able to get better terms if your business is financially strong.
If your business needs working capital to continue operating while invoices are outstanding, invoice financing can be a good way to receive funds quickly. Invoice discounting is a common form of invoice financing that works as an asset-based loan, using unpaid invoices as collateral. Invoice factoring is another form of invoice financing in which companies sell their unpaid invoices to the factoring company, which is then responsible for collecting payment from customers.