What's Invoice Financing?

What's Invoice Financing

Cash flow gaps can occur when businesses grow too quickly to keep up with their expenses, are newly established and are experiencing shortage on funds or cash reserves, are simply going through a financially distressing period of business. Companies, wanting to avoid filing for Chapter 11 bankruptcy, search for funding solutions through lenders offering decent rates, minimal fees and a means to obtain a loan without strict stipulations.
When you own a small business, you need to make sure you get the funding you need to succeed. That’s where invoice financing comes in. See how it can get you the money you need.

Invoice financing is the answer to many companies facing this cash flow dilemma. They’re saddled with the desire to have a flexible loan that won’t strap them with strangled expenses and anxiety about when the funds will be made available to them.

What Is Invoice Financing

Invoice financing is a creative funding solution that allows businesses to borrow money against the invoice amounts due from their customers. It’s a form of asset-based financing - using a company’s assets as collateral in the case of default. Should a business default on their loan, the lender can recoup their losses with the collection of accounts receivable invoices.

It’s a popular method. Almost all companies can find value in their accounts receivable and use them as assets to back their loans. There are also numerous advantages that come with invoice financing a company can reap, which we’ll touch on later.

How Does It Work?

The commonality behind invoice financing, sometimes called accounts receivable financing, is due to most businesses invoicing their customers on credit terms. Net 30-day, or sometimes even Net 60-day terms, are what the majority of companies issue to their customers. Cash flow gaps occur when customers are delayed in making timely payments. Companies are then stuck with expenses, outstanding accounts receivable and a lack of funds to pay them.

Lenders are in the form of invoice financing companies. Once you’ve established that your company has value in its outstanding invoices, the accounts receivable financing company steps in and receives them. The financing company issues the first installment of the loan: typically about 85% of the total value of your outstanding invoices.

Meanwhile, the second installment is put into a reserve until your customer pays the outstanding invoice. Then, this second advance is given to you, less financing fees. These financing or processing fees are a percentage agreed upon between you and your lender. Usually for invoicing financing, the percentage is around 3%, but it’ll vary depending on the lender’s going rates.

The fees aren’t limited to this second installment, however. Lenders may issue a small percentage charge until a payment from your customer has been made, which is referred to as a “factor fee”. It’s typically calculated on a weekly basis. If your customers happen to drag their feet on payments, this factoring fee can become pretty pricey, which is something to consider about this type of financing.

While both parties can benefit from a customer paying on their invoice, lenders issue this factor fee as a means for compensation on the time and effort it takes to collect on an invoice. It’s critical that before a company contracts invoice financing, that they analyze their customer base to determine if their customers are creditworthy. In the long-term, this will help the borrowing company avoid these amounting factoring fees.

The bottom line is that invoice financing is essentially a convenience fee paid to a third-party to collect on your outstanding invoices for working capital. 

Accounts Receivable Financing & Other Forms of Invoice Financing

There are other forms of accounts receivable financing. Invoice factoring and accounts receivable financing are the two most common means of invoice financing. They’re methodology is similar and understanding the difference can be challenging.

Invoice factoring differs only slightly from accounts receivable financing. The process of invoice financing, the collection of accounts receivable invoices is sold to a third party at a discount. The factoring company will then verify the invoices and issue the funds to your business for an immediate payment. The funds are issued in one to two business days. When customers pay their invoices, they make payments directly to the factoring company under the same terms. Then, the final part of the invoice factoring process involves the lender issuing the balance of the paid invoice, less the fee, in the second transaction of the loan.

The Pros of Factoring

  • More flexible than other forms of invoice financing as businesses can select the invoices they want to sell to the factoring company

  • Easier to qualify for than conventional loans, which is helpful for newly established, rapidly expanding or financially struggling companies

  • Is a simplified form of lending with an easy to comprehend fee structure that tracks the total costs, fees, and charges, on an invoice-by-invoice basis

In opposition, other forms of accounts receivable financing mimic that of a conventional bank loan, which we’ve previously discussed. A borrowing base is established, usually about 85%, and the business can draw against it. In this financing process, interest is only assessed on the amount of money borrowed. The outstanding invoices act as collateral, but unlike factoring they are not purchased but simply used as an asset in the case of default.

Accounts receivable financing can vary as well. For one, the premise is the same - your outstanding invoices are assets used as collateral -but this method splinters off, differing by means of a 100% advance from the lender. In exchange for receiving the full amount of funds, you must pay the lender back weekly, over an established, set period of time. This time frame is usually around 12 weeks, until the advance is cleared. You aren’t waiting for your customers to settle your debt. Instead, this loan allows you the complete funding up front, regardless of your customers’ payments on their outstanding invoices. This type of accounts receivable financing is a method that can provide funding for companies requiring it immediately.

The Pros of Accounts Receivable/Invoice Financing

  • Less expensive than invoice factoring

  • Although it isn’t as flexible as factoring because the invoices are used as collateral, it’s easier to transition to this type of lending than a conventional line of credit

  • Easier to qualify for accounts receivable funding than a traditional bank loan because the invoices act as valuable assets

To conclude, the difference that divides invoice factoring from invoice financing is that in a factoring scenario, a third party factoring firm purchases the outstanding invoices. Invoice financing is more in line with a traditional bank loan, using the invoices to fund an asset-backed loan.

An Alternative Solution for Financing

Invoice financing, whether companies opt for a factoring solution or accounts receivable financing loan, allow for a business that is struggling with cash flow a new opportunity to reprioritize. Financial strained companies can seek these types of invoice financing solutions from a non-conventional source. Lenders are made available in the form of factoring firms, a third party response to big-name financial institutions like banks or credit unions. 

With this type of lending, qualifications aren’t as strict, the loans and payment terms are more flexible, and companies can have a second chance at addressing their expenses and cash flow issues. Almost all companies have outstanding invoices that can be used as collateral (accounts receivable financing) or sold (invoice factoring). Invoice financing is a solution designed to remain in the lending market and to help business stand tall once again.