Invoice Financing for Small Businesses Explained – More Options for Businesses

Running a business should be all about improving efficiencies and getting the most out of the day-to-day tasks. It should not be about running after customers for payments owed. However, this is invariably the case with most businesses that are in work-related to manufacturing, supplying and distribution. Slow turnovers often result in non-payment of dues by customers that can cause severe delays and bottlenecks in operations.

Invoice Financing is the perfect solutions for business that require immediate cash flow . The immediate need for cash flow can result from a number of reasons; the company has spent most of their money on a previous order that’s been fulfilled, however, they haven’t received payment for this order. This company now needs additional capital for building inventory for new orders.

The can be one reason for why a company may need the additional capital, this is where Invoice Financing can help a business further their business interest when in lack of capital. This article takes you through the various facets of Invoice financing and how it can help your business through hard times.

What is Invoice Financing?

The term Invoice Financing is an amalgamation of two financial terms Factoring and Invoice Discounting. Factoring to put it simply is when a business sells its invoices, or receivables, to a third-party financial company). Invoice Discounting on the other hand is when an invoice financier releases funds from your unpaid invoices to help manage cash flow. The combination of both these aspects of financing is terms as Invoice Financing.

Read on for a more detailed understanding of Factoring and Invoice Discounting. This article covers both elements in its entirety. What is important to know is that many businesses are turning to factoring as a method of improving cash flow problems or to outsource the task of credit control from start-up maturity. This is a way to borrow money against a Sales Ledger, and as more businesses realise the value of this service, so the industry is growing. At the end of third quarter of 2017, the market in the UK was over £7.7 billion, this is a rise of about 36% on the same period in 2016.

How does Invoice Financing Work

In simple terms, the invoice financier and the company enter into an agreement which will usually be for a minimum specified length of time, typically 12 months, but sometimes as short as three. The invoice financier will charge a fee for handling the facility, and interest on the money lent on the security of the invoices.

The deal may be ‘without recourse’, where the invoice financier accepts the credit risks, or ‘with recourse’, where the seller retains the credit risks. In certain situations, such as exceptionally large value invoices, the invoice financier may require credit insurance , which will provide funds to reimburse them if they are unable to collect. The invoice financier providing finance on a ‘non-recourse’ basis is usually quite selective about the type of clients they will accept. If the business comes into one of their high-risk categories they may offer a smaller initial advance against invoices.

The invoice financier will accept export Sales Ledgers as well as domestic ones. And this can help where the cluster of payment can be very different from that of the UK. Although most foreign customers have someone who can speak good English, it is quite likely that their accounting staff may not. Intermediaries specialising in export finance have their own multilingual staff and may actually have an associate with an office in the debtors; countries to help collect troublesome accounts.

Generally, invoice financiers prefer a business to have a big spread of customer, but there are some that will find single debtor Sales Ledgers at lower advance percentage. If a big order is expected which will put a high proportion of a sales Leger with one customer, the invoice financier will expect advance warning to ensure the customer is creditworthy and provide guidance on the level of funding to expect on that invoice.

Types of Invoice Financing

Broadly speaking, there are two types of Invoice Financing. We provide a complete analysis of both the types of Invoice Financing.

1. Factoring

Factoring simply, is a way to allocate immediate finance for the value of sales invoices presented to a customer. Factoring also involves the financier collecting money owed by a customer on the company’s behalf. The financier will also be responsible for debt, and will buy the debt owed by the customer; usually by paying 85% of the debt upfront and the remaining 15% after it has collected the full amount.

The customer is made fully aware of by the financier about the company’s intention to go for Invoice Financing, and will be liable to pay the financier in full. Once the financier receives the payment from the customer in full, it deducts service fees and interest, before paying the remaining amount to the company. There are various parameters under which the invoicing financier calculates said amount, this includes initial negotiations, interest rates and finally the creditworthiness of the customer.

Pros

• The likelihood of bad debt arising is reduced or negligible as the responsibility of colleting payments for raised invoices then becomes the responsibility of the financier. Most financiers conduct a thorough credit checked, so as to reduce the risk of non-payment from customers.
• A company gets to focus on what is really important i.e. running the day-to-day business. It needn’t bother about running behind customers for payments on outgoing invoices.

Cons

• This may hamper your relationship with your customers, as the financier may handle your customer very differently than what you would expect.
• Your customers may ideally prefer to work directly with you for a number of reasons like data security and privacy.
• As there is an expense involved, the company will never receive the full payment for the they provide.

2. Invoice discounting

Invoice discounting is essentially a loan that the financier pays against unpaid invoices to the company. However, unlike in Factoring where the financier is responsible for invoice management and debt completion, the company has complete control. The entire process of invoicing is kept confidential, and the process makes little difference to the customer.

Pros

• The element of confidentiality is pertinent in this case. The customers don’t need to be aware of money borrowed for invoice created.
• Companies have complete control of the invoice collection process and can deal with their customers as per their present circumstances.

Cons

• The company needs to move away from their core function of running the business and collect money owed to them. This process can sometimes be quite time consuming and a drain on company resources.
• As this is a form of credit financing, a company’s ability to take future credit may be affected.

Recourse and Non-Recourse Factoring

Recourse Factoring is when a financier takes complete responsibility for the payment of the invoice that needs to be collected from a customer. Non-Recourse Factoring is when the company sells the invoices to the financier, who in-turn become liable for collecting money on the invoices. The financier is then fully authorised to collect payment from the customer using whatever method it wishes to; the financier may outsource this task to a debt collection agency if the need arises. Both Resource and Non-Recourse Factoring are available to a company; deciding between either, largely depend on the position of the invoice and at times the relationship between the company and the customer.

What is the Difference Between Factoring and Invoice Discounting?

The main difference is who collects the money from the Sales Ledger. With a factoring arrangement, the factor collects it, and so customers know that their supplier is using a financier. With invoice discounting, the supplier collects the money, and so customers are unaware that money has been borrowed against the Sales Ledger. Therefore, invoice discounting is often referred to as a ‘confidential’ service. Factoring costs a little more than invoice discounting, reflecting the more intensive service provided, but will almost certainly be more cost-effective than employing Sales Ledger and credit control staff.

In may also be and effective way of counteracting the bullying tactics of big businesses over timely payment. Another difference is in the size of turnover required. Some factors will accept a turnover of as little as 50,000 a year, but for invoice discounting it needs to be at latest 250,000.

Note:Invoice Trading is another product that has gained considerable popularity over the years. It gives more options for companies to pick and choose invoices they wish to sell. This is a viable option for a company that deals with a large corporation that is running multiple portfolios with the company. The company can pick and choose invoices for separate portfolios that require immediate payments.

Is Invoice Financing For You

Invoice Financing can have many benefits for a business. Especially for a small business that is struggling with cash flow, Invoice Financing gives it greater financial flexibility, which in some cases, can be a life saver. However, its important to keep in mind that Invoice Financing comes at a huge cost to profitability. Its therefore important to consider all possible finance options available, so as to ensure that it gets the best deal. We have done a short comparison between Invoice Financing and a Traditional Loan or Bank Overdraft to help you make up your mind.

Final Thoughts

Invoice Financing is a fairly straightforward concept which is borne out of requirement more than desire. The primary benefit of Invoice Financing is the immediate injection of capital into the business. For a company that is surviving on stiff margins the final pay-out offered by a financier may not be very alluring. A company that can foresee a shortfall of finances in the future, the option to go for a bank overdraft probably makes more sense as a cheaper alternative with more flexibility.

If you still feel that Invoice Financing is right for you, make sure you keep the following information in mind:

• Ensure that your credit control procedures are strong, and effective.
• Your customers are required to pay in a minimum of 30 days
• Your customers pay on time every time
• Ensure that you don’t have many bad debts, or at least limited to a minimum
• Your company turnover is at least £25,000 for a Factoring and £250,000 for an Invoice Discounting. (this figure could go up or down depending on the financier)

Note: If you have an inhouse accounting and credit management system, then the invoice factoring solution may be more appropriate. If you still have lingering doubts, you should consult with an accountant who understands the whole ecosystem. It is also important to remember to negotiate the best Invoice Financing deals ‘proactively’. We use the term proactively as financiers will base their decisions on various factors that they might term as ‘high risk’. Depending on these factors financiers will base their negotiations and your ability to negotiate a strong deal. Always remember that there are multiple financiers to choose from. Your risks can be further reduced if you have sold a few invoices, keeping the risk to a minimum. Additionally, its possible to offer insurance on your invoices that can also lower the risks for non-payment of invoices.

About the author

Sumit Agarwal
Sumit Agarwal (ACMA ACA India), the Managing partner of dns accountants is a highly respected accountant with expertise in helping owner-managed businesses.