What is invoice financing? Invoice factoring and invoice discounting
You will generally find there are two types of invoice financing available to businesses. They are:
- invoice factoring
- invoice discounting
The most important difference between them concerns control of your sales ledger or credit control, i.e. who is responsible for collecting payment from your customers. With invoice factoring, you hand control of collecting payment from your customers to the factoring company. With invoice discounting, you retain control.
How does invoice financing work?
After you raise a customer’s invoice, depending on your arrangement, the finance company will lend you somewhere between 75% – 90% of the invoice value. You will typically receive the money somewhere between 24 hours to 48 hours later. Once the invoice has been settled by your customer, you will receive the final balance, minus the finance company’s fees and charges.
Invoice financing costs and rates
Usually, there will be two sets of fees / charges for both types of invoice financing. Each will vary slightly depending on which option you choose.
Usually, the first set of fees will be for the finance provided. These are typically in the region of up to 4% above BOE base rate on the amount you borrow.
The second sets of fees will be an administration or service charge. The service charge is often paid monthly. It is usually somewhere between 0.25% – 3% of your gross annual sales turnover, and in many cases, there will be some degree of negotiability with it.
Generally speaking, given the credit control services of invoice factoring, factoring fees will be slightly higher than discounting fees.
How do invoice financing companies decide who to lend to?
In general, most factoring companies will prefer to work with you if you provide business to business services, rather than business to customer.
Some will ask you to provide proof of minimum turnover, though there are others out there who will work with startups.
For many companies, your suitability will depend on your client list. Typically, finance companies will tend to consider whether you have multiple clients rather than a handful of clients for example. They will also look at what your clients’ payment history is with you.
The finance company will look at your client’s credit history, rather than your credit history when deciding whether to work with you. Obviously, if you have clients with good payment histories, you will be a more attractive proposition than if your clients typically pay late, or stretch the terms of any agreements.
What happens if my customers don’t pay?
Most companies have the options for recourse or nonrecourse arrangements. If you have a recourse arrangement, you will be liable for any bad debts. This means that if your customers don’t pay you will have to pay back all the money you have been advanced in full plus interest and fees. In terms of your arrangement with the finance company, recourse arrangements will generally cost your business less in terms of interest rates and charges.
If you go for a non-recourse arrangement, you will be protected against bad debt, but your deal will likely include higher interest rates and fees.
Confidential invoice discounting: will my customers know that I’m using a finance company?
If you use invoice discounting, you will handle invoicing and taking payment from your customers. There is no reason why your customers should know that you are using invoice discounting.
If you use invoice factoring, taking payments from your customers will be managed by the factoring company, so ordinarily, your customers will know that you have used this service. However, there are some companies that offer a confidential service, so your customers won’t know that you are using a third party.
Pros and cons: how well does it work in practice?
- Fast cash: the most obvious pros if you are struggling with cashflow problems are that either of these methods release cash quickly. Once your agreements are in place (this usually takes 1- 2 weeks to arrange) you can access the cash anywhere from 24 hours to 48 hours later.
- Cash-flow forecasting: this may aid your cash-flow forecasting. Once you have raised an invoice, you will know how much of your invoice total is going to reach your account and when.
- Late payments and interest charges: however, if your customers are late paying, it will cost you more in interest fees. If they fail to pay, if you choose recourse financing, you will have to pay this money back subject to increased fees and charges. You can make a non-recourse agreement to avoid this, however this will have a further negative influence on your profitability.
- Reduced Profitability: whichever option you choose, invoice financing will negatively affect your profitability.
What will my customers think?
If you chose invoice discounting, you will retain control of your customer relationships and there isn’t necessarily any reason why they should know that you are using an invoice financing company. Similarly, if you use a confidential factoring service, as long as your customers make timely payments, they shouldn’t need to know that you are using a factoring service.
However, if your customers are late in making their payments, if you do use a factoring service, you will have no control over the processes that the factoring company uses to chase payments. You might find that your clients pay a third party quicker than they ordinarily would you, however, you might also find that your clients don’t like dealing with a third party. This has been known to cost some businesses their clients. Much of this can depend on how aggressive the factoring company is in chasing late payments.
In many cases, factoring companies screen your clients before agreeing to lend against your invoices. They may decline to lend, or impose trading restrictions or limits on the amount of funding they provide based on their findings. This can be awkward for your business relationships. In some cases, it can also lead to a loss of opportunities or sales.
How will it affect my business operations?
Outsourcing your sales ledger to a factoring company means you may save your business time managing it. However, some businesses complain that factoring companies are not as efficient as they might be in managing credit controls. To some extent, it is in the factoring company’s interest that your clients pay late, as your business will bear the costs of any late payments. It is therefore possible that you might end up paying more than anticipated because of poor service.
How will it affect my business relationships?
Some suppliers take a negative view of companies that use invoice factoring: they see them as higher risk. In some cases, this can negatively affect your business’ credit, terms and rates from your suppliers.
Similarly, it’s possible that it could reduce any alternative finance options available to your company. For example, it can be difficult to arrange further loans or credit because your invoices will no longer be an asset of your company. This can prove tricky for those wanting to end a business relationship with an invoice finance company. Typically, the finance company will require 3 months notice to end an arrangement. It will also need any loans to be repaid, plus interest and charges by the end of that period. For some companies with poor cash-flow, this can be a very difficult cycle to end, and they may need to arrange another type of finance to cover the shortfall. However, if their invoices are no longer a company asset, any alternative finance options available can be greatly reduced.
If you are temporarily struggling with cashflow problems, invoice financing can be a lifesaver. However, like any business relationship, it can be present certain difficulties. Whilst invoice factoring takes away the responsibility of managing your sales ledger, it can also be very restrictive. In some cases, it can ultimately have a negative influence on your business’s growth.
In general, invoice discounting will give you a greater control over the process than invoice factoring. It can present fewer obstacles in terms of perceptions of your company and your business relationships. However, again, you need to be certain that your company can bear the long-term costs on profitability.
Hence, we would always advise that you be careful to plan an exit strategy for this type of arrangement, and ensure that it works for your business, rather than against it.
If you are thinking about invoice financing, we have strong relationships with most of the providers for invoice finance, so feel free to contact us to discuss it. We can give you a realistic assessment of what types of finance might be available to your business.