Invoice financing is a way for businesses to borrow against unpaid invoices. With invoice financing, sometimes called accounts receivable financing, you sell accounts receivable to a lender instead of waiting for customers to pay their invoices.
You can get payment immediately, but this financing option has its downsides. Read on to see how invoice financing works and whether it is a good idea for businesses that need funds.
What Does Invoice Financing Mean?
Invoice financing is a term that applies to products that alleviate the financial pressure of waiting for customers to pay their invoices.
Companies use invoice financing to shorten their cash conversion cycle, or the time they need to convert their investments in inventory into cash, says Bob Castaneda, director of Walden University’s accounting and finance programs.
This short-term borrowing solution “helps companies to fund their working capital needs, such as paying employees, suppliers and other vendors, without worrying about when customers pay,” Castaneda says.
Invoice financing includes both invoice factoring and invoice discounting. The difference between invoice factoring and invoice discounting is who collects payment from the customer.
You’ll collect payments as usual from your customers with invoice discounting, but the lender collects from your customers with invoice factoring and could charge more for it. Here’s more about these types of invoice financing.
Your company sells control of your accounts receivable to a lender, at a discount, for quick cash. You might receive 70% to 90% of the value of your invoices upfront and the remainder, minus a fee, once customers pay their balances.
The downside to invoice factoring, other than the fee, is that your customers pay the lender directly. You no longer have control of the collection process, and your customers know you’re financing their invoices.
The lender typically advances your business 80% to 90% of the invoice amount, says Dan Karas, executive vice president of Allied Affiliated Funding, a division of Axiom Bank NA. Once your customer pays the invoice, you will repay the lender and receive the remainder of the invoice value, minus a fee for the service.
What Is an Invoice Finance Agreement?
An invoice finance agreement is a contract detailing the terms of the arrangement between the lender, or factor, and the business. A factor, or factoring company, is a funding source to purchase accounts receivable.
The agreement covers a number of issues. “Party names, who is responsible for which task, timing and dollar amounts are covered in the agreement, as well as how the lender or factoring agent will be compensated,” Castaneda says.
The primary components of an invoice finance agreement, essentially a purchase and sale agreement, are the advance rate, the fee, and whether the invoice is sold with or without recourse, Karas says.
“Recourse is the practice where the business and invoice finance company agree on the length of time the purchaser will own the invoice before it ‘charges back’ the invoice to the business,” he says. “The time is typically 90 to 120 days from the date of the invoice, though terms do vary based on the client’s business model.”
If the invoice is purchased without recourse, the factoring company absorbs the loss if the customer cannot pay. Recourse factoring is more common and means your business must make up any shortfall in invoice repayment. Factoring without recourse often has higher charges because the risk to the lender is greater.
How Much Does Invoice Financing Cost?
Invoice financing can come with some hefty charges. Finance charges will vary based on factors such as the average amount of time your customers take to pay invoices, the credit quality of your customers and the terms of your invoice finance agreement.
You may not only pay service fees but also interest charges on your balance. Application and termination fees can apply, plus late payment fees that may raise your interest rate.
Many lenders offer online calculators to help you determine the potential cost of invoice financing.
What Are Some Invoice Financing Companies?
Many companies provide invoice financing. Here are some of the main ones:
- American Receivable, which also offers credit lines of up to $5 million and allows your business to choose the invoices to finance
- BlueVine, which extends credit lines of up to $5 million and lets businesses select the invoices to finance at rates starting at 0.25% per week
- Paragon Financial, which advances 80% to 90% of invoice value at a rate based on your industry and your funding arrangement
- Rapid Finance, which offers invoice factoring of up to $10 million
- RTS Financial, which specializes in invoice factoring for trucking companies, with an advance rate of 97%
- TCI Financial, which typically advances 90% of invoices, with month-to-month or long-term contract options
Traditional lenders may also provide invoice financing. The benefit of a traditional lender is that it is a direct source of funds, which could mean lower borrowing costs compared with an invoice financing company.
- U.S. Bank has invoice financing through its partner, LSQ, which advances up to 90% of unpaid invoices for same-day funding.
- A division of The Southern Bank called altLine provides invoice financing services.
Is Invoice Financing a Good Idea?
Invoice financing might imply that a business is desperate for cash, but that is not always the case. Sometimes it is a good idea.
“One of the biggest constraints on growth and sustainability for businesses and nonprofits is cash flow for bill payments,” Castaneda says. “Invoice financing is a good way for organizations to quickly convert sales or revenues made on accounts receivable back into cash to help fund further needs.”
The lender, or factoring company, helps the borrower by managing the sales ledger and collections and providing constant access to cash, he says.
Invoice financing also allows businesses that don’t qualify for traditional financing to better manage their working capital needs, Karas adds. It is ideal for industries like trucking and temporary staffing, which may need to pay employees weekly, but often have to wait 30, 60 or even 90 days to collect invoices from customers, he says.
“Other characteristics that make invoice financing an appropriate tool is whether a business has high debtor concentration,” Karas says.
Debtor concentration refers to the percentage of your accounts receivable owed by a single debtor, or customer. A high debtor concentration usually means a less diversified customer mix and too much risk for a traditional bank loan.
But invoice financing companies are primarily concerned that the invoice is verified, the goods are delivered and the payment will be made.
Invoice financing is not without its downsides, though.
The type of financing you choose may mean losing control over your invoices and your customer experience. Customers may not appreciate that their invoices were sold to a third party, and poor collection practices could hurt your brand image.
There are no guarantees that customers will pay their invoices in full or on time. If they ignore your invoices, the factoring company could ask you to make up the difference or charge late payment fees, inflating the cost of what can already be a pricey service.