What is Invoice Financing?
Invoice financing is a way for businesses to borrow money against the amounts due from customers. Invoice financing helps businesses improve cash flow, pay employees and suppliers, and reinvest in operations and growth earlier than they could if they had to wait until their customers paid their balances in full. Businesses pay a percentage of the invoice amount to the lender as a fee for borrowing the money. Invoice financing can solve problems associated with customers taking a long time to pay as well as difficulties obtaining other types of business credit.
Invoice financing is also known as "accounts receivable financing" or simply "receivables financing."
Understanding Invoice Financing
When businesses sell goods or services to large customers, such as wholesalers or retailers, they usually do so on credit. This means that the customer does not have to pay immediately for the goods that it purchases. The purchasing company is given an invoice that has the total amount due and the bill's due date. However, offering credit to clients ties up funds that a business might otherwise use to invest or grow its operations. To finance slow-paying accounts receivable or to meet short-term liquidity, businesses may opt to finance their invoices.
Invoice financing is a form of short-term borrowing that is extended by a lender to its business customers based on unpaid invoices. Through invoice factoring, a company sells its accounts receivable to improve its working capital, which would provide the business with immediate funds that can be used to pay for company expenses.
- Invoice financing allows a business to use its unpaid invoices as collateral for financing.
- A company may use invoice financing to improve cash flow for operational needs or speed up expansion and investment plans.
- Invoice financing can be structured so that the business' customer is unaware that their invoice has been financed or it can be explicitly managed by the lender.
Invoice Financing From the Lender's Perspective
Invoice financing benefits lenders because, unlike extending a line of credit, which may be unsecured and leave little recourse if the business does not repay what it borrows, invoices act as collateral for invoice financing. The lender also limits its risk by not advancing 100% of the invoice amount to the borrowing business. Invoice financing does not eliminate all risk, though, since the customer might never pay the invoice. This would result in a difficult and expensive collections process involving both the bank and the business doing invoice financing with the bank.
How Invoice Financing is Structured
Invoice financing can be structured in a number of ways, most commonly via factoring or discounting. With invoice factoring, the company sells its outstanding invoices to a lender, who might pay the company 70% to 85% up front of what the invoices are ultimately worth. Assuming the lender receives full payment for the invoices, it will then remit the remaining 15% to 30% of the invoice amounts to the business, and the business will pay interest and/or fees for the service. Since the lender collects payments from the customers, the customers will be aware of this arrangement, which might reflect poorly on the business.
As an alternative, a business could use invoice discounting, which is similar to invoice factoring except that the business, not the lender, collects payments from customers, so customers are not aware of the arrangement. With invoice discounting, the lender will advance the business up to 95% of the invoice amount. When clients pay their invoices, the business repays the lender, minus a fee or interest.