Invoice financing allows businesses to improve their cash flow while waiting for their customers to make outstanding payments. Like any type of financial product, invoice financing has advantages and disadvantages to consider before making a final decision.
We’ll walk you through how invoice financing works, what types of businesses it’s suited for, and alternatives to consider before deciding what type of business loan is best for you.
Key Points
• Invoice financing is a type of small business financing that leverages outstanding invoices as collateral, providing businesses with immediate cash flow while waiting for customer payments.
• The process involves submitting invoices to a financing company, receiving an advance on the invoice amount, paying fees, and repaying the lender once the client pays the invoice.
• Invoice financing is beneficial for business-to-business (B2B) companies with longer billing cycles, seasonal fluctuations, or uneven revenue distribution. It’s less suitable for businesses with unreliable clients.
• Other financing options include inventory financing, merchant cash advances, and long-term business loans — each with different structures, costs, and suitability depending on the business needs.
What Is Invoice Financing?
Invoice financing is a type of small business financing that leverages the outstanding invoices owed to you by your customers. Also known as accounts receivable financing or invoice lending, invoice financing is considered secured funding because your company’s financial invoices serve as collateral for the funds you receive.
In addition to this traditional secured loan structure, there are several other kinds of invoice financing. One of these is invoice factoring, another form of invoice lending in which you sell your unpaid invoices to a factoring company for a percentage of the invoices’ face value. The factoring company then becomes responsible for collecting from your customers, making it an attractive option for businesses that don’t want to chase down unpaid invoices.
Another form of invoice financing is an accounts receivable line of credit. With this type of business loan, you take out a line of credit using a percentage of the value of your unpaid invoices as collateral.
While it’s not suitable for all types of businesses, invoice financing can help many companies with longer billing cycles.
How Does Invoice Financing Work?
Invoice financing is a fairly straightforward process with four key steps. Here’s how it works:
1. Submit an invoice: The process begins when you submit outstanding invoices to an invoice financing company. These invoices represent the money owed by your clients. At this point, the financing company will assess the validity of your invoices and the creditworthiness of your clients.
2. Receive funding: Once the invoices are approved, the financing company provides an advance on the invoice amount, typically around 70% to 90% of the total amount. This advance is quickly transferred to your account, providing immediate cash flow to fulfill various business needs.
3. Assess fees: In exchange for the advance, the financing company charges a fee, which can be a percentage of the invoice amount or a flat fee. This fee covers the service and the risk taken by the financing company. The exact fee structure varies based on the lender and the creditworthiness of the invoiced clients.
4. Repay the lender: When the client pays the invoice, you direct the payment to the lender. The lender then deducts the advance and the agreed-upon fees before sending the remaining balance to you. This completes the transaction, and the cycle can begin again with new invoices.
Invoice Financing Example
Invoice financing can be tricky because it often uses a factor rate rather than an interest rate to calculate how much you owe. A factor rate may have a short term — such as a week — which means that your obligations will build quickly even if the percentage you see is low. Let’s take a closer look at how it works.
• Submit an invoice: Let’s say you have a small business with an outstanding invoice for $20,000. You submit it to an invoice financing company.
• Receive funding: The financing company accepts your invoice and they agree to advance 80% of the invoice value, or $16,000.
• Assess fees: The financing company charges a 1% factor fee per week until your customer pays the invoice. If it takes four weeks for the customer to pay, the factoring fee would be $640.
• Repay the lender: You repay the loan amount plus the factoring fee — a total of $16,640.
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.
Invoice factoring is a kind of invoice financing, but it’s not a loan. Instead, invoice factoring is a type of cash advance based on your outstanding invoices. You typically give the invoices to a factoring company and receive an advance of up to 90% of the invoices’ amount. Once the customer pays the invoice to the factoring company, you’ll receive the remaining balance minus a factoring fee that is withheld by the factoring company. Instead of being charged an interest rate, you’re charged a factor rate that’s based on the risk of your invoices.
Invoice factoring usually shifts the collection process to the lender. With invoice financing, your business typically keeps control of customer relations and the collection of your invoice funds. If you opt for factoring, your customers will likely know that you’ve outsourced this part of your business. Some businesses may prefer keeping the collection process in-house to maintain customer relationships.
Both invoice financing and invoice factoring involve ongoing fees. Typically, the longer each invoice goes unpaid, the more you’ll pay in fees. An important note: These tiered rates add some uncertainty to how much you’ll owe, so be sure to have some flexibility in your business budget for these fees.
Pros and Cons of Invoice Financing
As with any business loan, invoice financing can help your business in several ways, but it also has disadvantages to consider. Here are some key pros and cons to help you decide if financing invoices is right for your business:
Pros of Invoice Financing
Here’s a look at some of the advantages of using invoice financing.
• Improves cash flow
• Provides businesses with a working capital boost during slow periods
• Allows continuity for businesses with long billing cycles who don’t want to operate order to order
• Easy application (usually a credit check and invoice documentation)
• Fast access to funds, sometimes within a day of application
Cons of Invoice Financing
• Can be expensive, with potentially high rates plus other fees
• Deprives you of a portion of your revenue
• Fees are in part based on whether your customers are making payments on time
• Using a factoring agency may involve them interacting with your clients, potentially affecting your relationship
Is Invoice Financing a Good Idea?
Invoice financing is certainly helpful in some business cases. If your company has seasonal fluctuations, a lengthy billing cycle, or revenues that aren’t distributed throughout the year — and your clients reliably pay their invoices on time — invoice financing may be a good way to keep regular cash flow through the highs and lows.
If your customers are slow to pay, however, the fees you’re charged may increase, and if they default, you may end up having to cover their invoices. If your business has less reliable clients, using funding like this could end up being costly in the long run and may not be a good fit.
How to Apply for Invoice Financing
Invoice financing is a valuable tool for companies looking to improve their cash flow by borrowing against outstanding customer invoices. Understanding the steps involved can help you make the most of this financing option and avoid potential pitfalls.
1. Determine whether your business is eligible: Invoice financing primarily benefits business-to-business (B2B) companies rather than business-to-consumer (B2C) companies. It’s not meant for businesses that 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.
2. Research potential lenders: 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, typically within the 70% to 90% range. A lender may charge a flat-rate fee or a percentage of the invoice total. Either way, the fee is deducted when the customer pays the invoice. Depending on the lender, you may also encounter other fees, such as a new account fee, a renewal fee, a minimum volume fee, and/or an early termination fee. It’s always a good idea to determine the full cost of financing before you sign a contract.
3. Submit your application and supporting documentation: When you apply for invoice financing, a lender typically reviews your business credit and the documentation of your unpaid invoices. A lender may also look at your clients’ payment history to gauge how likely they are to pay the invoices. A personal guarantee isn’t usually required, but check the terms of your loan to be sure.
Alternatives to Invoice Financing
Invoice financing is one of many options available to support your business needs. Here are a few other small business loan options to consider before making a final decision.
• Inventory financing: This type of financing is used to help businesses purchase new inventory in large quantities and can be useful before a busy season or when you experience sudden demand for your product.
You can apply for either a loan or line of credit with inventory financing. The amount you can borrow is based on the value of your business’s inventory, but typically, you can only qualify for between 20% and 65%. Lenders may also use liquidation value as a starting point, as some types of inventory can lose value over time.
Like invoice financing, inventory financing typically comes with higher costs than a regular business loan. You’ll also need to demonstrate a high inventory turnover rate to qualify for higher loan amounts.
• Merchant cash advance: A merchant cash advance is better suited to businesses with B2C sales. You borrow a lump sum, and 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 number of sales, rather than your credit history, is the most important factor in qualifying for a merchant cash advance. Generally, approval also happens quickly, allowing you to get fast access to funding.
• Long-term business loan: A long-term business loan can last anywhere from several years to 25 years. Rather than bridging cash flow gaps, this type of financing is usually used for larger investments, such as buying real estate, renovating a building, purchasing equipment, or acquiring another business.
Expect eligibility requirements to be stricter with a long-term business loan. Lenders may require you to have been in business for a minimum amount of time and have a strong business and personal credit history. Additionally, you may need to offer some collateral and meet a revenue threshold.
Recommended: 6 Step Guide to Getting a Small Business Loan
The Takeaway
Maintaining steady cash flow can be tricky for many small businesses. Whether you’re looking for a short- or long-term financing solution, finding the best type of loan for your business can take time and consideration. You’ll want to carefully weigh the pros, cons, and costs of each option to find a suitable option.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
Is invoice financing easy to obtain?
Yes, invoice financing is relatively easy to obtain, especially for businesses with creditworthy clients and strong accounts receivable.
How expensive is invoice financing?
Invoice financing can be expensive, with fees typically ranging from 1% to 5% of the invoice value per week. Actual costs will depend on the creditworthiness of your clients and the terms of the agreement.
Is invoice financing risky?
Invoice financing carries some risk, mostly related to the creditworthiness of your clients. If clients fail to pay their invoices, you might still be liable for the advance received.
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