What is Invoice Finance?

Invoice finance has become an increasingly common funding solution for SMEs. There are several primary reasons for that, and during the past couple of decades, some key events have changed the way small to medium-sized businesses are borrowing.

Firstly, the financial crash back in 2008 significantly transformed the way major banks treated commercial credit applications, and that inevitably changed the way small businesses operated. Secondly, uncertainty surrounding Brexit affected confidence and reduced traditional borrowing in the UK. In recent years, access to traditional bank lending has tightened for many SMEs. At the same time, businesses are increasingly looking for flexible funding options that help smooth cash flow without taking on long-term debt.

Traditional lending has been more challenging for newer and smaller businesses to access for a while now. During the pandemic, customers are paying more slowly, and that’s done nothing to decrease the intense pressure on SMEs to continue paying wages and suppliers. Commercial borrowers need a simple and accessible, cost-effective way to maintain their cash flow. All lenders base the cost of borrowing on risk, and freeing up the cash in outstanding invoices represents a relatively low-risk prospect.

What is invoice finance, and how does it work?

Invoice financing is a straightforward way to borrow funds, secured against the value in your unpaid invoices. Once an invoice gets raised, a lender advances a percentage of the invoiced amount to your business (usually around 90%) – and some providers guarantee settlement within twenty-four hours.

Depending on the type of invoice financing you apply for, either you or the lender will perform credit control, and when the invoice gets paid by your customer, you receive the remainder of its value, less the finance fee.

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Invoice discounting versus invoice factoring

The two primary types of invoice finance - invoice discounting and invoice factoring - differ only in terms of who is responsible for collecting payments. For businesses, there are two main factors to consider when choosing one of the two solutions; do we want customers to know we’re using the service? Do we want to outsource credit control?

Invoice discounting is the simplest of the two finance structures. You borrow on the value of the invoice but retain control over chasing payment. With invoice factoring, however, the finance company performs credit control, so your customers are going to know you’ve outsourced the operation.

• Both discounting and factoring work by advancing a portion of the outstanding payment – usually around 90% of the invoice amount – and then, the balance gets settled once your customer pays the invoice in full.

• Many lenders in this space will insist your main source of revenue needs to be from B2B sales, not B2C.

• Invoice finance is available to many SMEs, although lenders typically assess factors such as creditworthiness, sales ledger quality and trading history.

Related: Small Business Financing

Pros of invoice factoring

• For smaller businesses, having the finance company manage credit control can work well, and free up time to develop new leads or revenue streams.

• Because the finance company reduces its risk by managing your sales ledger, the bar to access this invoice financing method is lower. Most companies set a turnover-related limit.

Cons of invoice factoring

• The service isn’t confidential. Some customers may object to the fact you’re outsourcing credit control, especially if you’re a smaller business with a relatively close-knit customer base.

• The credit control element of invoice factoring costs money, so borrowing costs also get higher than with invoice discounting.

How does invoice discounting work?

• Allows businesses to predict cash flow better and immediately frees up most of the money contained in unpaid invoices.

• You manage your own credit control – the method is entirely confidential, and your customers won’t know you’re using invoice finance.

Pros of invoice discounting

• Invoice discounting is confidential, so while it provides the same finance benefits are factoring, you won’t upset any customers.

• You carry out credit control your own way, which is excellent if you have different processes for long-term or loyal and trusted clients.

• There isn’t a credit control element to the cost of finance, like with invoice factoring.

• Some invoice discounting providers offer flexible facilities that allow businesses to finance selected invoices rather than committing their entire sales ledger.

Cons of invoice discounting

• Discounting comes with a higher bar for entry – some financiers will specify a minimum turnover in the hundreds of thousands of pounds.

• Invoice discounting lenders may want to assess your capacity and procedures for credit control before they authorise borrowing.

Read More: What is SEIS? - Alternative small business funding

What are the costs of invoice financing?

That depends on whether you choose factoring or discounting, and as previously mentioned, the costs for invoice factoring tend to be higher due to the fact the lender takes care of credit control.

Typical fees for invoice financing are between 0.5% and 5% of the invoice’s value – however, as with all borrowing, your credit rating and other factors may influence the rate you get offered. The size of the invoice you wish to finance can also have an impact on the fee. Larger amounts tend to attract lower fees, while the opposite is true for lower-value invoices.

Who regulates invoice finance in the UK?

The FCA (Financial Conduct Authority) doesn’t currently regulate invoice financing, but UK Finance does have a code of conduct for providers in the space and providers may still be regulated for other financial services they offer. As with all finance, it’s a great idea to seek advice from your financial officer or accountant before you commit – especially if there’s an ongoing contract involved.

Why invoice finance has become popular

Invoice finance has grown in popularity because it allows businesses to unlock cash that is already tied up in unpaid invoices. Rather than waiting 30, 60 or even 90 days for customers to pay, businesses can access working capital almost immediately.

This type of funding is particularly attractive for growing businesses that need to maintain cash flow while continuing to invest in staff, suppliers and operations.

How does invoice financing work?

One of the main attractions with invoice financing is the simplicity of the structure. Your business raises invoices as usual, but then you let the financier know. Once they’ve got all the details, they’ll forward a percentage of the value. That can take anything from twenty-four hours to a week, depending on the invoice finance provider.

You’ll then proceed as per the agreement – if that’s a factoring arrangement, the lender will follow up with credit control according to their practices. If you’ve signed off on a discounting agreement, you’ll pursue payment as normal. When the invoice gets paid, you’ll receive the remainder of the money from the financier – who will deduct their fee. Once you’ve chosen and been approved by an invoice finance provider, repeat applications are easy and quick to arrange.

Can invoice financing help my business?

Invoice financing’s popularity has grown because it’s a relatively simple way to maintain a healthy cash flow in certain circumstances. However, it’s wise to use it as part of your broader cash flow projections and planning. Being reliant on any form of finance isn’t advisable. Still, as a supplement during periods when working capital is low, invoice finance can be a cost-effective solution for paying wages, suppliers, and even retail property rents.

If you’d like to find out more about how our accountants can help cure your cash flow problems and help your business thrive during these troubling times, get in contact with us at 0207 043 4000 or info@accountsandlegal.co.uk. You can also get an instant accountancy quote here.