Many small businesses provide goods or services to their customers and issue invoices for payment. These invoices usually have payment terms that specify when the customer should pay, such as 30 days. However, waiting for customers to pay can create a cash flow gap for the business. They may need funds to cover immediate expenses like payroll, purchasing inventory, or paying suppliers.
One solution is invoice financing. With this alternative type of business financing, a company is able to use its unpaid invoices as collateral to obtain a loan or line of credit from a financial institution, such as a bank or a specialized lender. This allows the business to improve its cash flow while waiting for customers to make outstanding payments.
But before you sign on the dotted line, it’s essential to carefully consider the costs and terms associated with invoice financing to ensure it’s the right financial solution for your needs. Here’s a closer look at how invoice financing works, its pros and cons, plus other financing options you may want to consider.
What Is Invoice Financing?
Invoicing financing is a type of short-term small business financing where companies leverage their unpaid invoices to access immediate cash. Instead of waiting for customers to settle their bills, the business uses these outstanding invoices as security to obtain a loan or credit line. Essentially, it’s like getting an advance on money owed by customers, which can help businesses address short-term cash flow needs without having to wait for payment.
While it’s not designed for all types of businesses, invoice financing (also sometimes referred to as accounts receivable financing) can help many companies with longer billing cycles.
How Does Invoice Financing Work?
Invoice financing primarily benefits B2B companies rather than B2C companies, which generally rely on individual customers who buy products through a point-of-sale system. Instead, it’s designed to let companies borrow against outstanding invoices for customer orders.
To qualify for invoice financing, you generally need to have accounts receivable from creditworthy customers that have a history of paying invoices on time. While the lender may also look at your company’s credit and financials, they usually aren’t their main concern. A personal guarantee isn’t usually required, but check the terms of your loan just to make sure.
Some lenders allow you to finance 100% of the invoice amount, while others limit you to borrowing up to a certain percentage of your outstanding invoices. When your customer pays the invoice, you’ll pay the lender back the amount loaned plus fees and interest.
The fee structure varies depending on your loan agreement, but typically invoice financing companies charge a flat percentage (1% to 5%) of the invoice value. This percentage may be charged for every week or every month it takes your customer to pay. So if your customers are slow to pay, costs can escalate; if they default, you may end up having to cover their invoices.
You may also encounter other kinds of fees with invoice financing, depending on the lender. There may be new account and renewal fees, a minimum volume fee, and/or an early termination fee if you decide to stop using the service. It’s always a good idea to check out the full cost of financing before you sign a contract.
Example of How Invoice Financing Works
Let’s say you decide to finance a $50,000 invoice with 30-day terms. You submit this invoice to a lender as collateral. The invoice financing company approves the invoice and provides you with a cash advance of 90% of the invoice ($45,000). The lender charges a 3% fee for each month the invoice is outstanding. Your customer pays the $50,000 invoice in three weeks, so your total fee for the advance is $1,350. Once you receive the customer’s payment, you repay the lender the money you borrowed plus fees ($46,350) and keep $3,650.
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Invoice Financing vs Invoice Factoring
Invoice financing and invoice factoring are terms that are easy to confuse. While you might even see them used interchangeably, they aren’t the same thing.
Invoice factoring, also known as accounts receivable factoring, differs from invoice financing both in terms of structure and repayment process. With invoice factoring, you sell your outstanding invoices to a factoring company at a discount. The company gives you a percentage of the invoice amount up front and then assumes responsibility for collecting the full amount from your customer. Once the customer pays the invoice to the factoring company, you receive the remaining balance minus a factoring fee that is withheld by the factoring company.
If you opt for invoice factoring vs. invoice financing, your customers will likely know that you’ve outsourced this part of your business. Some businesses may prefer to keep the collection process in-house to maintain their customer relationships.
Both invoice financing and invoice factoring involve ongoing fees. Typically, the longer each invoice goes unpaid, the more you’ll be charged. That adds some uncertainty to how much you’ll actually owe.
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Pros and Cons of Invoice Financing
Invoice financing can potentially help your business in a number of ways, but it also has its drawbacks.
Pros of Invoice Financing
Here’s a look at some of the advantages of using invoice financing.
• Improved cash flow: Invoice financing provides quick access to cash, which can help businesses cover day-to-day expenses, invest in growth, or handle unexpected costs.
• No debt: Invoice financing is not a loan, so it doesn’t add debt to your balance sheet. It’s a way to unlock the value of your invoices without taking on long-term debt.
• Flexible: You can use invoice financing as needed, depending on your cash flow situation. There’s no requirement to finance every invoice or maintain a minimum level of financing.
• Accessible: Invoice financing is often easier to qualify for than traditional loans since it’s primarily based on the value of your invoices and the creditworthiness of your customers.
Cons of Invoice Financing
There are, of course, some downsides to consider as well.
• Cost: Invoice financing can be more expensive than traditional loans or lines of credit. You’ll typically pay a fee plus interest on the advanced amount.
• Dependence on customers: Since invoice financing relies on your customers paying their invoices, you’re somewhat dependent on their payment behavior. If they pay late or default, it can affect your financing costs.
• Not suitable for all businesses: Invoice financing works best for businesses that have a steady stream of invoices from creditworthy customers. If your business doesn’t meet these criteria, you may not be able to use invoice financing.
• Potential for confusion with customers: If you opt for invoice factoring, some customers may be confused or concerned if they receive payment requests from a financing company instead of directly from you.
Is Invoice Financing a Good Idea?
Invoice financing can be a useful financial tool in some cases.
If your company has seasonal fluctuations, a lengthy billing cycle, or inconsistent revenues, but also has clients who reliably pay their invoices in a timely way, invoice financing may be a good way to keep a regular cash flow through the highs and lows.
If your business has less reliable clients, using funding like this could end up costing you in the long run.
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Alternatives to Invoice Financing
Invoice financing is far from the only type of financing out there. Here are a few other small business loan options to consider before you make a decision.
Inventory Financing
Inventory financing is short term, asset-based financing that’s used exclusively to buy the inventory or products your business sells. The loan (or credit line) is secured by the inventory or products that you’re purchasing. That means you don’t have to offer the lender any personal collateral. But if you default on the loan, the lender can repossess the inventory you purchased as payment.
Some lenders may finance 100% of the inventory value, but more typically a lender will offer somewhere between 50% and 80% of the inventory’s value.
Inventory financing can be useful before a busy season or when you experience sudden demand for your product. But like invoice financing, inventory financing typically comes with higher costs than a regular business loan. You’ll likely also need to demonstrate a high inventory turnover rate to qualify for higher loan amounts.
Merchant Cash Advance
A merchant cash advance can be better suited to businesses with B2C sales. You borrow a lump sum and then the lender automatically deducts a portion of your credit and debit card sales until the loan (plus accrued fees) is repaid.
As with invoice factoring, a factor rate is used with a merchant cash advance instead of an interest rate. Another similarity is that your sales history, rather than your credit history, is typically the most important factor in qualifying for a merchant cash advance. Generally, approval also happens pretty quickly, allowing you to get fast access to funding. Just keep in mind that the cost of borrowing is typically higher than other types of business financing.
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Traditional Business Line of Credit
A business line of credit is a flexible type of financing that allows a small business to borrow money up to a predetermined limit and will only charge interest on the amount of money borrowed (similar to the way a credit card works). Unlike a term loan, where you receive a lump sum of money upfront, a business line of credit allows you to borrow only the amount you need, when you need it. This can be useful for managing cash flow or covering unexpected expenses.
Business lines of credit typically have variable interest rates and can be either secured or unsecured, depending on the lender and the borrower’s creditworthiness.
Traditional Term Business Loan
Term loans provide a lump sum of money that is repaid over a fixed term, typically with a fixed interest rate (which is often lower than other types of small business financing). The funds can be used for a variety of purposes, including working capital, equipment purchases, and expansion.
This is a common type of business loan offered by banks, credit unions, and online lenders. Newer businesses typically have a better chance of approval through online lenders because they typically offer more flexible qualification requirements. However, interest rates tend to be higher.
Your business’s history, annual revenue, and creditworthiness (including your personal credit) typically determine which loan terms you’ll have access to and how much you can borrow.
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The Takeaway
Cash flow can be an issue for many small businesses. If your business is a good candidate for invoice financing and you need cash quickly, this type of funding may be able to help tide you over. Just keep in mind that costs can run higher than traditional banks loans and lines of credit.
If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.
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