What is invoice finance and should your business use it?

What is invoice finance?

Invoice finance is a collection of ways to monetise your outstanding invoices. Also known as invoice financing, accounts receivable financing, or receivables financing, invoice finance - broadly speaking - involves being fronted a percentage of the invoice's value by a third-party for a fee, with the party being repaid upon collection of the invoice. By using invoice finance, businesses can effectively get invoices "paid" within days, instead of the weeks or months it may take to collect payment in full from their customer. For small to medium sized businesses (SMBs), it can be a lifeline - improving cash flow, stabilising revenue, and in some cases reducing the risk of bad debt.

Invoice finance uses the debt owed to your business as collateral for invoice funding. There are three different methods of doing this. In short, you get paid now for the money that's owed to you at a later date – minus a fee that's typically less than 5%. (There can be, however, numerous hidden costs associated with invoice finance, so it's worth shopping around and reading the fine print before making a decision.)

In recent years, invoice finance has increased in popularity. This is partly due to the state of late payments - with large companies taking longer to pay small suppliers. As a result, SMBs are being creative in order to get their hands on the money owed to them as quickly as possible. Instead of waiting 30 days, 60 days, 90 days or even longer for large companies to pay their invoices, SMBs may turn to invoice financing companies to get paid immediately. It can be worth the cost in order to maintain good cash flow, or sometimes just to stay in business.

Types of invoice finance

There are three main types of invoice financing. Two of them have been in use for many years while the third – invoice trading – is a relatively new option that can be more flexible in some respects.

Invoice factoring

One of the two established methods of invoice financing is invoice factoring, sometimes known as factoring receivables. This involves "selling" invoice debt to invoice factoring companies. A small business factoring company may buy a business' invoices, typically paying up to 80-90% of the total amount to them immediately. The factoring company then receives payment from the business' customers in due course, after which it will pay the business the remaining invoice amount, minus any fees and disbursements.

In some cases the factoring company will manage credit control itself. In others, the business will handle that work.

Invoice discounting

Unlike invoice factoring, invoice discounting is a form of lending. Whereas many invoice factoring companies will take over the credit control on invoices they've "purchased", invoice discounting companies do not, nor do they receive payment directly from the business' customers. Instead, the discounting company lends the business a percentage of the money owed in the their accounts receivable ledger. In other words, the business' invoices are used as collateral for a short-term loan.

It's similar to having an overdraft that you can dip into to bridge the gap between issuing an invoice and being paid for it. There is, of course, a fee for this type of borrowing, but invoice discounting usually compares favourably with bank loans, as well as being easier to obtain. A bank will typically want to see profit and loss accounts going back months or years. Invoice discounting firms only need to know that your invoices are valid and your customers are creditworthy.

With invoice discounting leaving credit control in the hands of the invoice issuing company, this may be either an advantage or disadvantage. On one hand, conducting your own credit control can help maintain better customer relations, however chasing late-payers can be time-consuming and expensive.

Invoice trading

Invoice trading is a more recent concept than invoice financing and invoice discounting, and involves using online platforms in order to "sell" invoice debt to other companies or investors. It's a form of peer-to-peer business lending that cuts out the need for dedicated invoice financing companies. It offers a more bespoke method of invoice funding, giving SMBs more options.

For example, an SMB might choose to only trade those invoices to customers that have long payment terms, keeping the management of short-term invoice debt in-house. This is known as selective invoice finance. There's also the potential to get better rates and lower fees because there are more potential lenders to choose from, although they should all do due diligence on your – and your customers' – creditworthiness.

Invoice trading can be effective for companies trading internationally. This is an area in which traditional invoice financing companies are reluctant to tread due to the difficulty of chasing non-domestic debt. Online investors looking for returns are more likely to take on such perceived risks.

When your company should use invoice finance

There are many scenarios in which invoice finance could be helpful or even essential for your business. Here are some examples.

To keep working with valuable customers

If you work with big customers that insist on longer payment terms (e.g. 90 days versus 30), but they provide business that is too valuable to turn away, invoice trading could help you maintain relationships with these customers without having to sacrifice your cash flow.

To pay suppliers

If you have a short-term cash flow issue where suppliers are demanding payment for a large order that you haven't yet received payment from sales from, invoice discounting could allow you to borrow the money to cover those costs. It's likely to be cheaper and simpler than applying for a bank loan – and it's discreet so your customers won't know.

To take advantage of an opportunity

If you've spotted an opportunity for business growth but it requires you to invest in operations and new staff immediately - and your money is tied up in receivables - invoice factoring could allow you to get the bulk of that money now and also outsource credit control, allowing you to focus on the new investment opportunity without distractions.

Summary of invoice finance

Whichever form of invoice finance you choose, the underlying goal is the same – to get your hands on the money that's owed to you sooner rather than later. This improves cash flow, which is one of the primary factors in the health of a business.

Invoice finance is usually faster and easier to set up than conventional bank loans. It can be more flexible too, potentially offering the ability to get paid for individual invoices or a subset of the company's accounts receivable ledger.

Bear in mind that there are risks to any form of borrowing. That may be more of a risk for the lender than the borrower, but still it's important to understand the pros and cons as they apply to your specific business. If in doubt, ask your accountant for advice.