Invoice Financing & Factoring
A Comprehensive Guide To Invoice Financing & Factoring
12 Min. Read
Table of Contents
- Do You Need Invoice Financing?
- Invoice Financing in 5 Steps
- The Cost of Invoice Financing
- Who Invoice Financing Is Right For
- Pros and Cons of Invoice Financing
- Invoice Financing Frequently Asked Questions (FAQs)
What Is Invoice Financing?
Invoice financing is a term used for lending products that enable companies to collateralize unpaid invoices in exchange for a cash advance. In short, you’re converting assets (invoices) into immediate cash. And unlike traditional loans, you’re not generating any debt that must be paid back. You’re simply leveraging money that’s already owed to you.
Terms vary depending on the lender, but in general, an invoice financing company will advance businesses up to 80-90 percent of the funded accounts receivable value, deducting an overall processing fee and a weekly factor from the reserved portion until the invoice is paid in full.
The remaining balance is then remitted to the borrower in the form of a rebate.
Do You Need Invoice Financing?
Cash to business is like food to an organism. Your business can survive without sustenance—cash inflows—for some time. But once all reserves are used up, your company has no more sources to draw from and falters.
Unfortunately, this is a reality small business owners face every day. According to a U.S. Bank study, 8 in 10 businesses that fail do so because of cash flow problems. And for many small businesses, cash shortages often occur while waiting for invoices to be paid.
Just how big a problem is this for small business owners? Consider these statistics:
- 93% of businesses experience late payments from customers
- 47% of credit sales are paid late
- Typical payment terms are 27 days, but actual payment periods average 34 days
A business line of credit can sometimes hold you over while you wait on outstanding accounts receivables, but what happens when reserves aren’t deep enough to:
- Meet seasonal demands?
- Capitalize on a business opportunity?
- Pay employees, suppliers or bills during your slow season?
- Make necessary business improvements?
- Take advantage of a temporary supplier discount?
- Or hire additional employees to grow your business or fill a seasonal need?
Here’s where invoice financing, also known as invoice factoring, can help you bridge temporary cash flow gaps with instant access to the cash you’re owed.
While this option could be the financing solution you’re looking for, let’s examine the ins and outs of this funding option so you have a full understanding of how invoice financing works.
How Do Invoice Financing Services for Small Business Work?
Invoice financing, also known as invoice discounting, is a type of accounts receivable financing that converts outstanding invoices into immediate cash for your small business.
The financing company typically pays you in two installments: an advance of 80-90 percent of your invoice and the remaining 10-20 percent (minus fees) after the invoice is paid in full.
Let’s take a closer look into how this works:
Invoice Financing in 5 Steps
Step 1: Invoice Your Client With Net Terms
Once you have provided goods or services to your B2B customers, issue invoices with clear repayment terms. An example of a common payment term is Net 45 days, which means that payment is due at the end of 45 days from the date of invoice.
Step 2: Select Invoices for Financing
Pick the invoices you wish to finance. During this process, identify the receivables most valuable to lenders. Look for invoices with the following attributes:
- Newer invoices: You can increase your chances of qualifying for accounts receivable financing if your invoices have only recently gone past due (between 30-90 days).
- Smaller invoices: Small invoices are less of a risk to lenders for the simple reason that the less a company owes, the more likely it is to pay.
- Large, creditworthy companies: Unlike other small business loans, invoice financing companies assess the creditworthiness of an applicant’s clients rather than the creditworthiness of the applicant alone. For this reason, it is in your best interest to select invoices issued to established companies with strong annual revenues and histories of timely repayment.
Step 3: Lender Advances Percentage of Invoice
Once approved, the invoice financing company issues you a percentage of the funded invoices, known as the advance rate. The amount of the advance rate depends on many factors, including the size of your transaction, your industry and other risk parameters. But in general, you can expect to receive 80-90 percent of the financed accounts receivable value.
Step 4: Factoring Fees Accrue Until Invoices Are Paid in Full
The financing company deducts a processing fee, typically around 3 percent, and a fee known as a factor (or discount rate) each week until invoices are paid in full.
Step 5: Lender Forwards Reserve, Minus Fees
Once outstanding invoices are paid, the lender issues you the reserved balance, known as a rebate, minus the above-mentioned fees.
The Cost of Invoice Financing
One of the most significant advantages to invoice financing is the straightforward cost structure. Though fees vary by lender, expect to pay a single processing fee on each invoice you finance and a weekly factor until the invoice is paid in full.
To help you understand this cost structure, let’s walk through a typical scenario.
Invoice Financing Cost Structure
In this example, the invoice financing company charges a one-time processing fee of 3 percent and a monthly factor of 1.02 (2 percent of the total invoice value) until the invoice is paid in full.
If you finance an invoice for $20,000, the cost structure will look like this:
Amount of Financed Invoice: $20,000.00
One-time 3% Processing Fee: $600.00
1.02 Monthly Factor Rate (.5% Weekly): $100.00 per week
The invoice financing company advances you 85 percent of the funded invoice.
Amount of Financed Invoice: $20,000.00
85% Advance Rate: $17,000.00
It takes your customer a total of 90 days (12 weeks) to repay the invoice. As a result, the invoice financing company deducts $1,800.00 from the reserve amount.
One-time 3% Processing Fee: $600.00
Factor Fee: $1,200.00 ($100 X 12 Weeks)
Total Invoice Financing Cost: $1,800.00
The invoice financing company issues a $1,200 rebate.
Total Invoice Financing Cost: $1,800.00
Rebate Owed to Customer: $1,200.00
Who Invoice Financing Is Right For
Though incoming payments may be on the books, not having them on hand can prove problematic—whether you’re experiencing a cash flow shortage or you’re looking for funds to capitalize on time-sensitive opportunities.
Let’s review some of the ways you can leverage invoice financing in your small business:
- Bridge gaps in cash flow
Whether you operate a startup or mature small business, cash flow shortages happen. It could be that you’re in the middle of a seasonal lull or a critical piece of equipment failed unexpectedly, depleting your cash reserves. Invoice financing can help you fill temporary cash flow gaps so you can continue to meet your various financial obligations.
- Pursue growth opportunities
In today’s competitive business world, you can’t let business opportunities pass you by. Unfortunately, the funds required to pursue such opportunities aren’t always available when needed. Rather than wait up to 90 days or more for payment from your customers, you can finance open invoices and have the money to invest in new opportunities to set your company on an upward growth trajectory.
- Keep up with new demands
Rapid success also creates a need for steady cash flow. For example, to keep up with a surplus in demand, you may need to purchase more material and hire more staff. Invoice financing can provide you with access to required working capital.
But the question remains: Who qualifies?
In short, you’re eligible for invoice financing if you extend credit to businesses for your goods or services with clear repayment terms.
Invoice Financing Qualifications
Unlike other short-term funding options, the creditworthiness of your business is less of a deciding factor. What’s essential in invoice financing and factoring is the creditworthiness of your customers. As such, you can expect invoice financing companies to perform a business credit check, reputation analysis and a thorough examination of your customer’s payment history with your business.
While there are fewer minimum requirements, the health of your business is still relevant and will influence offered advance and factoring rates. For example:
- If your revenue is trending up for six months or more, you will be considered a stronger candidate and may be offered more favorable terms.
- The more accounting history your provider has to review, the better your profile may look. This is especially important for businesses that operate in industries labeled as “risky” for lenders.
When Does Invoice Financing Not Make Sense?
Invoice financing isn’t a good fit for long-term investments, such as consolidating high-interest business debts, startup funding, equipment financing or commercial real estate. Rather, invoice financing is intended to provide short-term working capital to meet immediate financing needs, like payroll and other operating expenses.
Pros and Cons of Invoice Financing
While invoice financing is a popular working capital management option for all businesses, it’s important to weigh the pros against the cons before pursuing this funding option.
The pros of invoice financing include:
- Near-immediate access to cash
You can be approved in hours and funded as fast as same day.
- Easy application process
Applying for traditional loans is notoriously a time-consuming process that requires a lot of paperwork. This is not the case with invoice financing. The online application takes only minutes to complete and asks for simple business details and contact information.
- Low qualification requirements
If you’ve been turned down by banks, this may be the financing solution you need. Approval, advance and factor rates are primarily based on the credit of your customers, not your business.
- No collateral required
Invoices act as collateral, so no additional collateral is necessary.
The cons of invoice financing include:
- High cost
The cost of invoice financing versus other short-term options is favorable if your customers repay invoices quickly. However, it can become more expensive than other options if it takes longer (more than three months) to repay the advance.
- No guarantee of collection
If your customer doesn’t pay its invoice, you’re still on the hook to repay the lender, as with a standard business loan.
- Qualification is outside your control
Qualification, advance and factor rates are primarily based on the credit of your customers, not your business.
Alternatives to Invoice Financing
While invoice financing is an excellent option for many businesses, it might not be the best option for your particular funding need. For example, you might not have enough invoices on the books to cover a cash flow shortage. The good news is, you have options.
Some potential alternatives to invoice financing include:
- Business Line of Credit
A business line of credit provides you with access to funds to spend as your company sees fit. You can withdraw according to your business need and will only pay interest on the funds that you use.
- Short-term Business Loan
A short-term loan provides your company with working capital in a lump sum that is paid back in 18 months or less.
- Merchant Cash Advance
A merchant cash advance is funding provided by your lender in exchange for a portion of your credit or debit card sales. This is a great option for businesses looking for fast and easy funding with flexible qualifications.
Invoice Financing Frequently Asked Questions (FAQs)
As with any lending program, some questions are asked more frequently than others which we’ve tried to address here.
What Happens When My Customer Pays Their Invoice?
It depends on your lender agreement. There is typically no change in how your customers pay their invoices. They’ll remit payments to your business entity. You then make payment to your lending provider. However, with some providers, the amount you borrowed is automatically repaid when your customer pays their invoice directly to the lender.
How Quickly Can I Get Funding?
A benefit of invoice financing is its quick funding. With invoice financing, the application process takes minutes. If approved, you’ll receive funding in your bank account as fast as same day.
Will My Invoice Financing Provider Contact My Customers?
No. Invoice financing does not require the sale or assignment of your invoices to your provider. This means you’ll maintain control of your customer communication. Your customer relationships are unchanged and continue to operate as usual.
How Can I Qualify for Invoice Financing?
While qualifying for most short-term business financing is based on your business’s creditworthiness, that’s not the case with invoice financing. Since repayment is tied to your customer, the ability of your customer to repay is typically the most important qualification. Thus, your provider will consider both your customer’s and your business’s criteria when determining eligibility and rates.
How Do I Choose an Invoice Financing Provider?
An important first step is to research the invoice financing firm to make sure they’re reputable. Next, compare the offered terms. Making sure you can meet the stated financial requirements is essential. Additionally, consulting with a trusted advisor is an excellent way to hone in on a reputable firm.
With the guidance of Fast Capital 360’s Business Advisors, you can compare all your invoice financing options from the industry’s top providers in one place. Through our simple online application, you can be approved within hours and even receive funding as soon as same day.
Is Invoice Financing Your Best Lending Option?
As we covered, invoice financing may be the funding solution you need to fill temporary cash flow gaps. Instead of waiting up to 90 days for customers to pay you, you can leverage your unpaid invoices for immediate access to capital. You can then use that capital to carry your business through hard times or fund important growth opportunities.
It’s important to remember that invoice financing is best used to bridge a temporary gap in cash flow. If you’re looking for long-term business funding, it’s best to consider another type of business loan.
1 2016 payment practices study by Atradius