Invoice finance can facilitate payments of up to 85% within 48 hours from your clients’ invoices. Invoice financing is a process that enables you to finance your accounts receivable. It’s a convenient choice for both large and small companies.
It provides some sense of security over the payment of their invoices. Unfortunately, many businesses are yet to take advantage of it, yet it comes with several benefits. The lack of understanding of how the process works is the main hindrance.
Here, we’ll delve into what you need to know about invoice financing. Read on!
The Basics of Invoice Financing
Invoice financing is a process that encompasses many products. The three most common ones are factoring, discounting, and asset-based financing. In general, invoice financing is a way that allows businesses to borrow money against what their customers owe them.
The arrangement is also known as receivables financing.
Through the process, companies can significantly improve their cash flow and meet their financial obligations. They can pay suppliers and employees on time and reinvest in growth without having to wait for the invoices to mature.
Invoice financing works best when a business has difficulties obtaining other forms of business credit. It also works to solve the problem of delayed payments from customers. Upon repayment, the borrower pays a percentage of the invoice amount as a fee for the loan.
Why Invoice Financing?
Most businesses sell goods or services to their customers on credit. The customer doesn’t have to pay for the product immediately after purchase. The buyer is issued with an invoice showing the amount and date due.
Giving credit to customers ties up money that a business would otherwise use to run its operations. Invoice financing comes in to help finance slow-paying accounts receivables and enhance short-term liquidity.
This form of short-term borrowing is extended by the lender to a business based on unpaid invoices. Companies can structure invoice financing in a way that the lender has no explicit control over it.
Invoice Finance from a Lender’s Perspective
From the eyes of the lender, invoice financing is an advantage to the lender. This is because, unlike extending a line of credit, the invoice acts as collateral. It leaves little recourse in case the business is unable to repay the loan.
The lender reduces the risk level by not advancing 100% of the invoice amount to the borrower. Unfortunately, the process doesn’t eliminate all risk as the customer might never pay the invoice. This results in a problematic and expensive collection process that involves the bank facilitating the invoice financing.
The Structure of Invoice Financing
Here are the three main ways that a business can structure their invoice financing. It all depends on one that will work for your case.
1. Factoring
Invoice factoring is a process that entails selling outstanding invoices to a lender or finance company. By doing so, the business can get about 70-85% of the value of the invoice up front. Once the lender receives payment for the invoices, it remits the remaining 15-30% to the business.
The business then pays interest or the applicable fees for the service to the lender. The lender then collects payments from the customers, an arrangement that the company should notify the customers.
Most lenders establish an invoice factoring line within a few days. Once the line has been established, getting the funds takes a day. The arrangement works well for companies giving a 30-day term to their clients, but need money sooner.
How to Qualify for Factoring
The structure of invoice factoring makes it easier to get funds than through conventional financing. Since the company is selling an asset, which is the invoice, lenders are more willing to extend the facility. The qualifications demand that the company
- Has creditworthy commercial clients
- Is free of encumbrances like liens and judgment
- Has good invoicing practices
- Invoices for delivered goods or services
The invoice factoring arrangement is available to both small and mid-sized companies. Newly established businesses with a few assets can also qualify.
The Cost of Invoice Factoring
Most factoring lines will cost a business between 1.15% and 4.5% every 30 days. The lines of factoring can be structured in several different ways depending on the financial situation of the borrower. For example, an arrangement with an average of 2% every 30 days can be extended as follows:
- 1% ever 15 days
- 2% for the first 30 days and 0.65% every ten days after the 30 days lapse
- 0.67% every ten days
All approaches amount to 2% for the whole 30-day period. Choose an arrangement that works best for your business situation.
Advantages of Invoice Factoring
Factoring has gained popularity among firms as a way of growing a business. This method of financing, just like all others, has its advantages and disadvantages. By being familiar with them, you can make an informed decision on whether it’s the best solution for your business.
Some of its advantages include:
I). Improves Cash Flow
With invoice factoring, a company is in a better position to cover immediate expenses. Payments to suppliers and employees are made in good time.
II). Extension of Payment Terms
When a business knows it can factor its invoices without hitches, it can give its customers better credit terms. For example, 30-day terms can be extended to 60 days as you don’t have to wait that long to get the invoices paid.
III). Easy to Qualify
Unlike the conventional lines of credit, factoring doesn’t ask for many requirements. A business with stable and reliable customers should have no problem qualifying.
IV). Quick Processing of Funds
Funds from invoice factoring take a week or two to be dispensed. This provides you with a fast response in case your company is in a crunch.
V). Line Flexibility
Once you establish a line for invoice factoring, you can grow it to adapt to your growing revenues. This is one advantage that can help businesses grow to the next level.
VI). Easy to Apply
The process of applying for invoice factoring is more straightforward than most other business loan solutions.
Disadvantages of Invoice Factoring
Invoice factoring may not necessarily be the best solution for every business. It comes with some of the following difficulties.
I). Costly
Invoice factoring will cost you more than most other financing solutions. You need to weigh your options if you’re looking for a cost-effective solution.
II). Situation-Specific
Invoice financing is designed to address the specific problem of unpaid invoices. It cushions your business against slow-paying clients, hence ensuring you have constant cash flow. If you need money for other things like funding a project, factoring may not offer much help.
III). Your Customers Must be Informed
When factoring your invoices, your clients will have to know. They’ll receive a Notice of Assignment from the lender advising them of the factoring relationship. This can reflect badly on your business relationship.
IV). Your Invoices Have to be Verified
Most lenders will check the status of your invoices with the customers. They must first establish that the invoices are accurate and that the customers are satisfied. This may take a while, depending on your customer’s responsiveness.
2. Asset-Based Financing
The asset-based loans provide a revolving source of finance, with the accounts receivable acting as collateral. Just like invoice factoring, the arrangement improves the cash flow of a business. The agreement is more common with larger companies that invoice at least $750,000 monthly.
It’s more like a stepping stone to getting a line of credit from the bank. They are harder to get than invoice factoring but more accessible than a bank loan. It’s important to note that asset-based financing serves to finance a company’s assets.
These include equipment, invoices, inventory, and machinery.
Setting up an asset-based financing facility takes longer than factoring. It’ll take about three to four weeks, depending on the complexity of the situation. After the setting is in place, getting the funds will take a day or two.
A company can request for funds through a schedule that’s lenient to their needs.
The process of asset-based financing needs more documentation than factoring. As a business, you’ll need to ensure you have good financial statements and a record that shows profitability.
How Does It Work?
Asset-based financing is more like the conventional line of credit. It’s an avenue that allows your company to draw funds while invoicing clients. You then pay the line of credit once customers pay up.
This line of credit allows you to get up to 85% of the value of accounts receivable. This may vary depending on the industry, client concentration, and credit quality of your receivables.
The borrowing company must fill a borrowing certificate to access the funds. The document is used in calculating a borrowing base, which determines how much you can get. On the certificate is a list of all your outstanding receivables and other assets.
Next, the ineligible assets are subtracted, and the resulting amount is applied against the available line of credit. How your line of credit operates revolves around the information on the borrowing certificate. Hence, it’s crucial that your company has an accurate and updated accounting system.
Qualifications For Asset-Based Financing?
Any business that has a B2B business model can qualify for asset-based loans. The first condition is that the firm must have outstanding receivables. The lenders don’t care much for the profitability, revenue, or time the company has been in business.
Since the invoices act as collateral, lenders want the assurance that the invoices make financial sense. The other details about the business aren’t too important. The amount a business qualifies for depends on the value of the invoices as well as business creditworthiness.
Some lenders will take a look at your financial credit report too before financing you.
Costs of Asset-Based Financing
Asset-based line of credit has two sets of expenses. One is the diligence cost, and the other is the operation cost.
The due diligence cost is payable upfront to cater for the costs of underwriting and originating the account. In some situations, underwriting may call for onsite field audits. The due diligence costs can cost anything between $2,500 and $20,000.
The figures depend on the complexity and size of the transaction.
The operation costs refer to the actual costs of getting the funds. It’s calculated based on the prime rate. This is the most commonly used benchmark used in setting equity lines of credit. In turn, it’s based on the federal funds rate, established by the Federal Reserve.
The prime rate is also the underlying index for most credit cards, auto loans, home equity loans, and personal loans. In the same way, most small business loans are also indexed to the prime rate.
3. Invoice Discounting
Invoice discounting works in almost a similar way as factoring. The primary difference is that here, the business, not the lender, is responsible for collecting payments from the customers. This means that the customers aren’t aware of the arrangement.
In this arrangement, the borrowing business gets up to 95% of the invoice amount from the lender. Once the customers pay up, the company pays back the lender with interest or a fee.
Advantages
Invoice discounting presents you with the benefits of:
- Quick cash
- Reduced collection period
- Improved cash flow
- No assets required for collateral
- Doesn’t affect the customer-client relationship
- Allows room for sales on credit
- The seller exercises control of the invoices
With invoice discounting, a company can choose to grow sales through cash or credit. Transactions on credit are quickly converted into cash.
Disadvantages
It also has several cons that you need to know:
- Decreases profit margins
- Only works for commercial invoices
- Leniency in credit terms affects productivity
- Not suitable for new businesses
The amount a company can receive through invoice discounting varies depending on the value of accounts receivables. The company can also become very dependent on invoice discounting.
Final Thoughts
Companies that sell goods or services on credit can benefit from invoice financing. This refers to getting funds from lenders against the unpaid invoices. Three conventional approaches to invoice financing are factoring, asset-based financing, and invoice discounting.
Each process of financing has its own set of requirements. However, what every lender wants to see is the creditworthiness of the borrowing company. The business must also have proof that its customers will honor the invoices in the stipulated time.
Failure to honor the invoice means that the business will incur losses while paying back the lender. It may also lead to a long and tedious collection process between the parties involved.
Before settling for any invoice financing option, weigh the pros and cons of each, and make an informed decision.
If you’re looking for a loan, be sure to find out more about our business loans.