What is Invoice Finance and How Does it Work?

invoice finance

In the world of business, cash flow is king. If you can’t pay your bills on time or need to buy equipment or invest in expansion without waiting for your next round of financing, invoice finance could be a useful tool. Invoice finance (also known as factoring or account receivable financing) comes in many forms, but it essentially allows businesses to sell their invoices upfront in exchange for a cash advance. In this article, we explore everything you need to know about invoice finance, including why it might be right for you and what the pros and cons are.

What is Invoice Finance?

Invoice finance is a way of borrowing money based on what your customers owe to your business. It works by using unpaid invoices to represent money that will be paid to you, avoiding the usual wait for the payment terms. This can be anything from 14 days to 90 days, or even more, depending on the payment terms. Invoice finance ensures you get most of the cash immediately, so you don’t have to wait to get paid.

Types of invoice finance

There are two kinds of invoice financing that businesses can take advantage of, invoice factoring and invoice discounting. Both invoice financing products allow businesses to maintain control over their finances. Whether you want to maintain control over your company’s cash flow or have the lender manage it for you, both products provide the services you need.

Invoice Factoring

Invoice factoring is an agreement with a third-party company, the factor, to purchase your accounts receivables at a reduced amount of the face value of the invoices (typically 70% to 90% of the total)

Difference between invoice financing and invoice factoring

Unlike invoice financing, these contracts often offer to handle invoicing and debt collection on your behalf. Invoice factoring can minimize your credit risk as it doesn’t require you to put up collateral, but it does mean you effectively lose control of your client relationship since it is the factor, not you, that will collect the money from your customer.

Invoice discounting

Invoice discounting is a short-term borrowing against outstanding invoices that enable you to sell unpaid invoices to a lender, who then gives you a cash advance based on the percentage of the invoices’ value. The lender gives you the remaining balance after your customer pays the invoice

The credit management fee for Mwananchi Credit Ltd invoice discounting could range from 0.2 – 5 per cent of gross turnover, while typical fees for a factoring agreement are likely to be between 1 and 3%.

Difference between invoice financing and invoice discounting

Unlike invoice financing, the process of invoice discounting is confidential and customers are usually unaware the business is using a financial provider, unlike in invoice financing where the customer is aware that there is a third party involved

How does invoice finance work?

Invoice financing can be considered a business financial option since you can collect cash immediately, without waiting for your customers to pay you in full. This in turn keeps your working capital topped up and you can avoid the credit and cash flow problems that may occur if customers take a long time to pay

The invoice financing process

  • You provide the goods/services for your customers and immediately invoice them.
  • You send those invoice details to the invoice financing provider (the lender).
  • You receive a percentage of the face value of the invoice, usually within 48 hours (the percentage depends upon the lender’s risk criteria).
  • You collect payment from your customers as usual.
  • When your customers pay you, you settle your account: reimbursing the lender and retaining the portion of the invoice that wasn’t part of your invoice financing agreement, less a service fee

Are there costs involved in invoice financing?

Yes, there are costs involved in invoice financing.

The lender will charge interest on the amount you borrow, as well as fees (generally a percentage of the invoice totals). Taken together, this can represent a total of up to 30% of the value of your invoices in annual interest.

You are responsible for collecting the invoices due from your customer and must reimburse the lender for the amount borrowed.

The pros of Invoice Financing

Quick access to capital:

Because invoice financing is asset-based lending, you don’t need to prove that you have sufficient cash flow to make payments on the loan. Instead, you use your invoices as collateral to secure the loan. This makes it easy to gain access to capital quickly, which is ideal when you have a short-term need for cash but don’t want to rely on credit cards or other high-interest forms of debt.

Less expensive than a loan:

While invoice financing is a form of debt, it’s often less expensive than a traditional business loan. This is because there are no credit checks and minimal documentation requirements, and the interest rates tend to be lower because there’s less risk for the lender.

The ability to put off payment for a few months

If you know your customer will eventually pay their invoice, you can use invoice financing to put off payment for a few months — giving you time to collect the invoice before repaying the loan. This gives you the ability to access cash when you need it while still being able-bodied to collect on the invoice.

Boosts credit sales

Invoice discounting can help convert credit sales into cash, which means SMEs enjoy quicker growth and development in a shorter amount of time.

Quicker turnaround

Compared to other types of business loans, invoice financing has a very quick turnaround. You could avoid having to ever wait again for the payment period by submitting your business invoices for invoice financing.  

The cons of invoice financing

You’re banking on one customer to pay:

When you use invoice financing, you’re gambling that one customer will pay their invoice for you to make good on your loan. If they don’t pay, your lender will come after you so it’s important to monitor your accounts receivable to make sure you don’t have any late payments.

Potential impact on your credit:

One of the drawbacks of invoice financing is that it can negatively impact your credit. Because your lender is making a claim against your invoices, your accounts receivable will appear on your balance sheet as a liability. This can affect your overall debt-to-equity ratio, which is often a factor in calculating your company’s credit score.

You have to pay the loan back

If you use invoice financing, you have to pay back the loan with interest. This means you’ll have to find additional cash flow or make cuts elsewhere in the business to pay it back.

Your customers will need to be other businesses

Invoice financing is only available on commercial invoices meaning your customers have to be other businesses, not the general public.

Invoice factoring and client relationships

If you choose to apply for invoice factoring, then chasing payments will be out of your hands. This means your client relationships could potentially be impacted by this and there’s a risk of damaging these relationships.

Key takeaway

Although invoice finance is a form of debt, it’s often less expensive than a traditional business loan. When you use invoice financing, you’re banking on one customer to pay their invoice in order for you to make good on your loan. It’s important to monitor your accounts receivable to make sure you don’t have any late payments. There’s also a risk that your use of invoice financing will negatively impact your credit. However, invoice finance can be a quick and easy way to access cash when you need it.

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