Invoice finance is used by companies to speed up payments for goods and services. Rather than waiting 30, 60 or 90 days for a customer to pay, a company can sell its invoices to lenders who advance most of the value immediately.
Let me explain using two analogies. When I buy a pint of beer in the pub, the bartender pours the beer and puts it down on the counter. I pay for the beer and then I can enjoy my drink. This is a typical business-to-customer transaction which involves immediate payment.
In contrast, if I own a company that makes pencils and I receive an order worth £100,000 for one million pencils then I freight the pencils to the purchaser and send out an invoice for £100,000. This invoice sets out a legal contract. The company buying my pencils must pay me £100,000 within a specified time period. If that time period is 30 days, the purchasing company will pay on day 30, giving itself the longest possible time to raise the money.
However, I need to replenish my stock of pencils as well as pay my wage bill, utility bill and taxes. Rather than struggling for 30 days, I can use invoice finance to receive most of the £100,000 due to me immediately.
The benefits of invoice finance (also called invoice factoring) are easy to discern: it eases cash flow problems. It allows companies to be paid quickly so they don’t face financial problems that could be costly and that could slow down the development of the company.
Benefits of Invoice Finance
There are four key benefits to invoice financing. They are:
- Quick turnaround. In contrast to other funding options, invoice factoring allows companies to be paid quickly for their goods and services. There is a quick turnaround from delivery of product or service to payment of that product or service.
- Quick cash. As soon as an invoice has been raised, cash can be made available using invoice factoring. This cash can be used strategically to grow the business, pay suppliers or settle bills.
- Boosts credit sales. Rather than being overly cautious, a company can quickly convert credit to cash. This is vital to all businesses, especially SMEs who might be reluctant to go into debt to fulfil a large order.
- No risk to assets. A bank or lending institution will require collateral if a company wanted to borrow against a future payment of an invoice. This means there is a risk to company assets in using a bank loan. In contrast, invoice financing does not require a company to put its assets up as collateral in case there is a payment default.
Invoice factoring companies buy unpaid invoices for a percentage of their worth. The difference between what they pay out and what they receive is essentially their fee. In return for this fee, invoice factoring companies provide ‘credit control’ services to make sure the invoice is paid on time. They remove the cost and time involved in chasing up customers with outstanding invoices to pay, allowing a company to focus on their business.
Invoice factoring companies will do a credit check on potential companies for their clients. They will provide an assessment of whether a buyer can realistically pay up within the specified time period.
Moreover, the buyer will be alerted that an invoice factoring company is involved in the transaction. Whereas a small company might be reluctant to pursue legal avenues to expedite the payment of overdue invoices, invoice factoring companies are experts in legal disputes over payments.
Lastly, new and small companies might not be able to access bridging loans from banks to help cash flow while they are waiting for an invoice to be paid. In this instance, invoice finance provides an excellent alternative.
Is Invoice Financing Right for You?
There are a few points to consider before exploring the option of invoice factoring further.
- Invoice financing is only available for business-to-business transactions. This means your customer has to be another company, and not a member of the general public.
- Another point to consider is client relations. When an invoice factoring company is used, it takes on the task of chasing up debts. This can affect customer relations as it is the invoice factoring company that is communicating with your customer, not you.
- Finally, there is the consideration of costs. Invoice financing is a great short-term solution to cash flow problems but it has to be remembered that invoice factoring companies charge interest fees as well other processing fees
Selective Invoice Factoring and Spot Factoring
A company has discretion over which clients and which invoices they choose for invoice factoring. A company may decide that they only need to use invoice factoring for a few customers. This is called selective invoice factoring. Alternatively, they may decide that they will only employ an invoice factoring company for specific invoices. This is called spot factoring.
Such flexibility allows companies to better manage their cash flow as well as their client relationships.
A More Detailed Example
To return to my example of the pencil company selling one million pencils for £100,000. Perhaps that company needs to employ another member of staff to ramp up production. It also needs to purchase more raw materials for the factory. Cash flow is an issue so the pencil company approaches an invoice factoring company and is offered the following terms:
85% of the invoice paid up immediately. The rest paid when the invoice is paid. The total cost to the pencil company in costs and fees is 3%.
Thus, the pencil company will receive £85,000 within a couple of days of showing the invoice to the invoice factoring firm. When the invoice is paid by the buyer of the pencils the money (£100,000) goes straight to the invoice factoring company. They will take their fee of 3% (£3,000) as well as the money they lent to the pencil company (£85,000). In total they therefore keep £88,000 (£3,000 + £85,000 = £88,000). The remaining money (£12,000) is paid to the pencil company. Thus, the pencil company can employ a new member of staff and get on with making more pencils. They avoid any cash flow problems and the invoice factoring company gains £3,000 as its fee. This, in a nutshell, is invoice factoring.