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What Is Invoice Financing and How Does It Work?

Marcela OteroJun 25, 2017

Invoice Financing at a Glance

Invoice financing is a way for businesses to obtain funds based on amounts due from their customers. This can take two forms. Invoices can be sold to a factoring company in exchange for immediate payment, (known as invoice factoring), or receivables can be used to secure a revolving line of credit via an asset-based loan (called accounts receivable financing).

Invoice Factoring vs. Line of Credit: What's the Difference?

Invoice factoring allows companies to sell their accounts receivable to increase their working capital. This is done by obtaining immediate funds which can be used in turn to pay for company expenses. Since this technically involves selling an asset, factoring can be easier to obtain than traditional financing, especially for small businesses who don't yet have substantial assets or a long credit history. The most important element in order to qualify is to have invoices from creditworthy commercial clients. 

This is substantially different to how a line of credit works, in which a financial institution establishes a maximum balance from which borrowers can obtain money in a revolving fashion, periodically making payments and taking out money. 

How Accounts Receivable Financing Works

Accounts receivable financing, on the other hand, obtains financing by using a company's receivables (their outstanding invoices, or the money owed them by customers) as collateral in a financing agreement. In this type of agreement, an accounts receivable financing company gives the original business an amount equal to a reduced value of the unpaid invoices or receivables. 

Typically, the financing company advances between 70 and 90 percent of the value of the outstanding invoices, usually within one day of approval. Once the debt is collected, the remainder is paid out to the company, less the finance fee. Even at a reduced rate, obtaining funding in this way is extremely useful for companies with an abundance of unpaid debts, and it transfers the default risk to the financing company.

Invoices are, of course, verified before being funded. This is done in order to determine that the invoice is due, and that there are no issues that might prevent its payment, such as disputes or chargebacks. Generally speaking, new invoices are more valuable than old invoices, and those from larger, established concerns are more valuable than those from small companies. The easier the factoring company feels a bill is to collect, the more valuable it is. Conversely, the harder a bill is to collect, the less it is worth.

Another way for invoice or accounts receivable financing to work is called invoice discounting. In this alternative, the business itself collects the payments from customers, not the lender. The customers are therefore never aware of the arrangement. 

How Much Financing Can You Get?

The maximum amount of financing a company is able to obtain depends on a number of factors, including the total amount of invoices, their quality, and the company's creditworthiness. Some accounts receivable financing lenders also take a look at the business owner's individual credit score, as well. Most lenders approve customers who have generated over $130,000 in annual revenue, possess a credit score of 600+, and have been in business for over twelve months. 

What Will Invoice Financing Cost Your Business?

Once a company agrees to collateralize some of their invoices for funds from a financing lender, and has been advanced the agreed-upon percentage of said invoices, the remaining is held in reserve and subjected to fees, until paid off by the customer. From that remainder of between 30 to 10 percent of the invoices, lenders first collect a processing fee, usually around 3%. They then charge a factor fee (commonly between one and three percent), which is calculated on a weekly basis, and depends directly on the amount of time it takes for the customer to pay up. Once payment occurs, the borrowing company receives the 30 to 10 percent of the remaining invoice, minus the processing and factor fees, which are the price they've paid for obtaining immediate cash. 

Essentially, then, invoice financing costs more or less depending on the speed with which customers settle their bills. Invoice financing is a convenience fee for a business' access to working capital. An easy way to calculate rates is with this handy calculator

Pros & Cons of Invoice Financing

Invoice financing can be an easy, convenient way to leverage money from future payments. Some advantages include:

  • Outsourcing sale ledger management, thereby freeing up time for actually managing the business
  • Potential customers are credit-checked, making it more likely to trade with customers who pay in a timely manner
  • Immediate access to working capital, without needing to wait on customer payments 

However, there can also be disadvantages to relying on immediate payments in order to meet your financial obligations, such as:

  • It can make it look like your business is struggling financially to meet its short-term financing needs
  • Higher fees than traditional financing
  • Using invoices as collateral may inhibit your ability to obtain other sorts of funding, such as conventional loans, which typically include accounts receivable as part of their collateral as well

What You Need to Qualify

In order for a company to qualify for invoice financing, lenders typically look for businesses with good credit and reliable customers, and who can prove that the debt can be collected within a reasonable timeframe. Generally speaking, lenders have a minimum amount of annual revenue, and sometimes they also set limits for the number of invoices that must be met on a monthly basis. 

Some essential documents for factoring include a detailed list of customers, financial records, sales ledger, any details of the outstanding invoices to be funded, and occasionally, a written guarantee by a company director is also required.