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Introduction to invoice financing: The pros and cons of the finance method

Business Advice | 25 January 2016 | 8 years ago

Invoice financing: Providing capital against invoices
Writing for Business Advice, founder of factoring and discounting broker Factoring Solutions, Ian Johnston, introduces us to alternative financing methods that could provide many answers to small firms.

Often small and medium sized businesses struggle to maintain a healthy balance between operational costs like paying employees, or buying products and materials, and income. If the discrepancies are too high, a business’s operating cash might grow dangerously thin.
Many firms have experienced stagnation: barely making ends meet with little chance of growth. This is a position no business owner wants to find themselves in.

What is invoice financing?

Invoice finance is a relatively new method of business financing when compared with traditional banking services. It allows a business access to the funds in invoices that have not yet been paid. It may sound complicated at first, but it’s in fact simple once you understand that unpaid invoices are assets. Invoice financing provides money based on these assets. There are two main types of invoice financing.

Invoice discounting

This service lends money equal to a high percentage of a given invoice. A business can usually draw between 75 per cent and 95 per cent of the invoice value in 48 hours after using the service. When customers pay, the money is processed by a financing company and you as the company pay the fee. An owner will still have to chase down clients and make sure debts are managed appropriately. This service can be a discrete relationship between a business and a funder. So customers don’t need to know.


Factoring acts in a similar way to invoice discounting, but in this case a funder actually buys the invoices from you as the business. A higher percentage of the amount received right away can be taken, and when invoices get paid the factor forwards the remaining amount minus fees and charges.

The main operational difference is that the factor becomes the owner of the invoices and the client therefore owes payment to the factor. The business is no longer responsible for sale ledger and debt protection and credit control are included in the service. However, if a client gets treated unfairly by the company funding the firm, it might negatively impact business relationships.

But, can’t I just go to the bank?

The variety of UK businesses in recent years has increased hugely. Individuals have found ways to make money out of the most unusual products and services. The internet, especially, has provided a platform for many intelligent entrepreneurs creating niches that standard businesses never dreamed of exploring, like uploading music to people’s iPods, for example.

Such alternative businesses often cannot make good use of banks, since banks are looking for secure investments. Even so, for Catherine (the founder of the above mentioned service) this niche activity is good business. Banks are a lot more conservative and will be reluctant to provide a decent financing solution. But exceptions are often available.

Even if you own a very traditional business, like a commerce shop, banks might still not provide an option. When considering to lend, banks exclusively research a company’s credit history. Best intentions, unfortunately, are not necessarily good business. Sometimes, even though business owners try their best, credit checks might turn out ugly. In these cases, banks will not lend, as the business will not seem like it will pay back without hassle.

The main difference with invoice financing is the factoring company will look carefully at the credit history of a firm’s clients, not the firm itself. This means that even if your business is on the wrong foot financially, it might still be possible to receive invoice-based funding.

The pros and cons to invoice financing

The fact that factoring and invoice discounting are often widely available doesnt necessarily mean either is what’s right for a business. In fact, picking the wrong service, or the wrong service supplier might even make your financial situation worse. Regardless, there are many good perks that business owners should be aware of:

(1) Quick access to your funds
A business receives the largest part of unpaid invoice values 48 hours after submitting them to a factoring company. This enables a business to operate efficiently and optimise cash flow for maximum returns with minimum spending. When cash isnt available, businesses are often forced into bad deals just to get by.

Having cash untied will give you unprecedented opportunity to grow a business and expand. More stock and materials can be bought, thereby providing services to larger clients with larger wallets. Vendors will almost certainly provide better deals and rates, when purchasing large amounts.

(2) Confidentiality
With invoice discounting you also get the benefit of confidentiality. If a business chooses to manage client accounts, the relationships remain close with them, giving clients due attention whilst receiving the benefit of instant funds.

(3) Outsourcing sales ledger
With factoring you will receive bonus services like the outsourcing of a sales ledger. The factoring provider will take care of a sales ledger on its own, leaving owners to run businesses rather than chase unpaid invoices.

(4) Business security
Before buying an invoice, a factor will credit check a client thoroughly. This way, businesses are likely to deal with customers that can and will pay.

(5) Negotiations with vendors
Some invoice factoring companies can assist in negotiations with suppliers. This way businesses might receive a better deal on products, materials and services for increased profits.

The perils of using invoice finance:

(1) A portion of profits is lost
Businesses must remember that these services are not free. Factoring companies will usually charge a flat rate calculated from a given invoice. Also, there is usually a second fee that is based on how quickly an invoice is repaid by the client. Balancing between the flat commission and the interest is important when picking the appropriate service for a firm.

(2) Businesses might face restrictions
If a factoring company finds clients to be untrustworthy, it might impose trading restrictions on a business, or place a limit on the funding it provides. This can get really awkward and might end up with the loss of opportunities or sales.

(3) Businesses might experience a bad sales ledger
A lot of factoring companies provide cheap flat quotes, but lead very ineffective credit controls. This leads to longer payment periods, and higher fees. In the end, a business might have to pay a lot more than anticipated due to poor service.

(4) Valuable customers might be lost
If a business opts for factoring and sells invoices, it might lose control over communication with clients about payments. There has been more than one case where in order to receive money faster, a factoring company treats a client less than ethically. This can impact on customers very negatively and ultimately they might destroy business relationships.

Invoice discounting generally gives businesses greater control and fewer obstacles. It resembles more traditional ways of receiving finance, but like traditional banking, firms are left with the responsibility of handling repayments. Factoring takes away some of that responsibility, but can also impose new restrictions that might ultimately hinder business growth.

In the end, like any other financing options, invoice finance can make or break almost any business. There are many businesses that have found the required boost and push to reach new levels of growth. Likewise, there are many who have gone out of business because a poor choice was made.

If owners have not experienced this type of business finance they should do some heavy reading on the subject rather than take rushed decisions. Alternatively, seek consultation from a factoring broker, making sure they are not tied to any financial organisation. Otherwise businesses might end up on the other side of the fishing pole by funding providers.

Understanding the various funding options available to your small business can be a daunting prospect. Why not read Business Advice’s guide to national grants to get clued up on another area of financing.

Ian Johnston is founder of factoring and discounting broker Factoring Solutions.


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