Invoice Finance

What is invoice finance?

Invoice finance is a collective term for debt facilities that use outstanding invoices, i.e. your debtor book or trade receivables as a form of loan security. The facility allows borrowers to access cash that is otherwise tied up in unpaid invoices.

Many businesses use invoice finance as a funding solution to unlock working capital to improve cash flow.

What types of invoice financing are there?

Invoice finance options, as a form of asset-based loan facilities, comes in the following forms.

  • Invoice factoring
  • Invoice discounting

What is invoice factoring?

Invoice factoring is the process of a business selling its outstanding invoices, at a discount, to a third party. In practice, the invoice financier will typically be a bank or factoring company.

The invoice finance provider will provide the credit control function to recover unpaid invoices. The advantage to the borrower is that this frustrating and time-consuming task is administered by the lender. This makes it a great financing solution for small businesses with this skills gap.

Invoice factoring is often referred to as accounts receivable factoring, debt factoring, or factoring.

What is invoice discounting?

As with invoice factoring, invoice discounting allows you to unlock cash that is otherwise tied up in outstanding customer invoices.

In contrast to invoice factoring, invoice discounting facilities do not provide credit control services (so you will need to collect from clients yourself). You should consider the opportunity cost of performing the credit control function in-house if you are deciding between invoice factoring and invoice discounting.

You may see an advantage in retaining the credit control function. It does allow you to have a form of dialogue with your clients. Additionally, there's continuity in service, concerning who owns the credit-control dialogue.

Many writers claim invoice discounting has an advantage over invoice factoring because your clients won't know you're using an invoice finance service. I would advise caution here and remind you that any charge or debenture registered against your business will be publicly available.

Recourse or non-recourse?

A recourse facility means you must suffer the cost of an unpaid invoice. This could mean a big cash flow and P/L hit if your client does not pay.

Conversely, a non-recourse facility involves the lender being burdened with the bad debt. Recourse and non-recourse, as terms, seem to be used more in academic circles by people studying finance. Oftentimes, you will see non-recourse service labeled as "bad debt protection".

There is an obvious advantage with a non-recourse facility but be aware that they come with a higher cost. If you're thinking this sounds like a good mechanism for taking on non-credit-worthy clients with no risk, think again. The lender is unlikely to offer bad debt protection or any type of invoice finance facility to your non-credit-worthy clients.

How much does invoice finance cost?

Most invoice finance providers prefer high volume and high-value invoices.

A high volume of invoices is good for the lender because it means there is more likely to be liquidity in the security, i.e. the invoices are turning to cash and, there is also an economy of scale.

Your invoice finance provider is likely to have preferences over sector and industry but a range of businesses will still be suitable. Sectors and industries with straightforward payment cycles e.g. recruitment agencies will be more attractive to Lenders.

As with other forms of finance, you will likely have more than one type of cost with any invoice financing arrangement.

The main types of expense related to invoice financing are:

Factor rate or discount rate

  • Similar in nature to an interest rate. This is the fee charged to you by your lender for releasing or advancing cash to you.
  • The factor charge is normally calculated as a percentage of the value of the invoice multiplied by the length of the factoring period. The factoring period is the length of time it takes your customer to pay the invoice.

Factor Fee

  • A factor fee Is a fixed fee for each invoice processed. If the value of your invoices is low, and in a high number, the factor fee will be more expensive than high-value, low volume.

Application fee

  • Whether you pay an application fee or not will depend on the lender and the circumstances around your application.

Credit check fees

  • Invoice finance companies may perform credit checks or review the credit rating of your business.
  • They may also perform them on your clients. This is to minimise the risk of advancing cash against sales invoices related to uncreditworthy customers.

Mailing fees or Credit management fees

  • If your invoice finance facility includes the lender communicating with your clients you may, or may not see this fee applied. It is often included in the factoring fee but you should be aware some lenders may apply this fee separately.
  • The lender may also have an annual management fee that they apply. This is often a percentage of revenue.

Credit Protection fees

  • This will only apply to a non-recourse facility.

Advantages of invoice finance

  • Quick access to funds by releasing the cash in unpaid invoices can support business growth ambitions.
  • A cash advance will help address cash flow difficulties.
  • Invoice financing can allow you to take on bigger projects without the need to worry about slow payment from your customer.
  • Invoice factoring allows you to outsource the headache of credit control.
  • The borrowing amount will increase with revenue growth. Any ambitious business owner will see the value of this.
  • There is more flexibility about how much you borrow and how often than most other business loans.
  • In many cases, the sales ledger will act as the loan security. This makes a great funding facility option for younger businesses that may not have loan security otherwise.
  • Allows you to extend credit terms to your clients.
  • Allows you to pay suppliers quickly. This will help build relationships in your supply chain and possibly even enjoy early payment discounts.
  • The lending criteria and basic functionalities are easy to understand.
  • Many businesses will qualify for an invoice finance solution. This form of lending is more flexible than a standard secured business loan or an unsecured business loan.
  • If it is a non-recourse facility you will get bad debt protection from non-payment of invoices.
  • Your funding partner should provide a dedicated relationship manager.
  • Invoice financing options include a single invoice finance facility.

Disadvantages of invoice finance

  • It can be expensive. You should always model/forecast the cost and use of any loan facility. For more guidance on picking the right loan facility please check out my guide on "Living with the loan".
  • Your customers may become aware you have an invoice finance facility. Whether this is a disadvantage or not really depends on your circumstances. Debt finance isn't bad (I do make a living out of it though!) but your clients may disagree. Your clients may also have their own opinions on the pecking order of lenders.
  • Invoice finance facilities are limited to B2B transactions, so if your customers are consumers you won't be turning invoices into cash with invoice finance (there may be other options available though).

Invoice finance frequently asked questions

What is the difference between invoice factoring and discounting?

  • Both facilities allow businesses access to cash that is otherwise tied up in the accounts receivable faster than may otherwise be the case.
  • Invoice factoring comes with a credit control function, invoice discounting does not.
  • There's more likelihood of your customers becoming aware you have an invoice factoring partner than if you had an invoice discounting partner.
  • Invoice factoring is more expensive than invoice discounting because you're effectively paying a premium for the outsourced credit control function.

How long will the process take?

  • It can be as quick as a couple of days but you should budget up to one month from application to facility going live.
  • If you're transferring between providers you can expect to be on the longer end of the time frame.

Can start-ups access invoice finance?

  • Yes, but the options will be less wide-ranging than for established businesses with longer trading histories. Many lenders will also have a minimum annual turnover requirement but there are funding options for low annual turnover businesses.

How much money can I borrow?

  • Some invoice finance lenders will lend up to 100% of the value of your invoices. Most tend not to exceed 80%–90% though.

How much do invoice finance facilities cost?

  • The total cost will depend on how long you use the facility and the combination of fees the invoice finance lender applies. You can expect a combination of the below:
  • A setup fee or processing fee or subscription fee- to set up your account.
  • A service fee — normally applied as a percentage of unpaid invoices.
  • A finance fee or discount fee — typically charged as a percentage of funds lent to your business. Similar to interest expense.

Can I use an invoice finance facility without my clients knowing?

  • Many invoice finance providers will provide a confidential or discreet service.
  • If a charge is required, you should be aware that this will be publically available information (at Companies House). While you won't need to draw your client's attention to this, you should be aware of the fact.

How long are the contracts?

  • This varies between lenders. Some offer rolling contracts with a minimum notice period but most will have some length of tie-in.
  • If you're unsure, you can always ask for a trial period but the reality is once you start with a lender you're unlikely to leave. This is why choosing the right lender is so important, you don't want to go through the administrative burden and expense twice.
  • Most lenders will impose early exit fees and a minimum notice period if your contract is on a rolling basis.

Can I switch between invoice finance providers?

  • Yes, and some providers will even do the admin on your behalf.

Is invoice finance better than a bank overdraft?

  • Banks are often justly criticised for moving slowly.
  • If you're a growing business invoice finance may offer more flexibility than a bank overdraft. E.g. as your revenue increases so does your invoice finance facility. A bank overdraft or revolving credit facility is more rigid, in the sense that the credit limit is set and you will need to negotiate any changes.
  • If you'd like to learn more about overdrafts and revolving credit facilities please check out my guide.

Can you provide invoice finance facilities if my clients are overseas?

  • Some invoice finance providers will fund sales invoices for overseas clients. The providers that do will have certain criteria, such as a limit on the total percentage of your sales related to overseas clients.
  • Providers will also have certain Countries that they will not cover, particularly if the Country lacks a functioning government, has a high risk of fraud or has sanctions against it.

What security do I need to set up an invoice finance facility?

  • Some lenders won't require additional security but this will depend on your individual situation and the requirements of the lender. The market for this service is wide, so don't feel you have to accept the first offer you get. You can negotiate and shop around.
  • You should expect the following requirements from lenders though:
  • A personal guarantee.
  • Certain indemnities, such as fraud indemnity.
  • A debenture or charge registered at Companies House.

Why do my clients have to make payments into a trust account or controlled account?

  • This is to do with the legal transfer of ownership and as a security control for the lender.

What happens if my customer doesn't pay an invoice?

  • There will be an agreed period of credit that your customer can enjoy. This is usually up to 90 days but some lenders will be as low as 30 days. This period of time is known as the recourse period.
  • If your client doesn't pay within the recourse period funding will be removed.
  • Many lenders will give you the option of paying extra for bad debt protection. I would advise caution here though as a lender is only likely to offer this protection for the most credit-worthy clients.

Do my customers need credit checks?

  • Yes. The lender will look at data on your customers.

Can all my invoices be funded?

  • Yes, unless you have individual customers that aren't eligible. Your lender will inform you if this is the case.

What are Spot finance and single invoice discounting?

  • Also known as selective invoice finance, this facility allows you to raise cash against individual invoices.