Updated on 24th July 2024
As a business owner, managing cash flow is an ongoing challenge.
Both Invoice Finance and Letters of Credit can be valuable financial solutions to help with access to necessary working capital. But each option serves different purposes and comes with different advantages.
If you are not sure which solution is right for you, we will break down what each option entails, along with their pros and cons, to help you decide which is a better fit for your business and your needs.
A Guide to Invoice Finance
Invoice Finance allows easier cash flow management through accessing the unpaid money due to a business in their outstanding invoices.
How does it work?
First, you ‘sell’ your unpaid invoices to a third-party financial provider. This is sometimes referred to as the ‘factor’.
The factor then pays you a percentage (up to 95% at ScotPac) of the invoices’ value upfront. Once your customer has settled the outstanding invoices, you receive the remaining amount minus the agreed fee.
Types of Invoice Finance
There are different types of Invoice Finance depending on your needs.
Invoice Factoring
Invoice factoring is when you sell the entirety of the outstanding invoice to a factor and they handle the debt collection themselves.
Invoice Discounting
This is when you ‘borrow’ money against the unpaid invoice or invoices. You then repay the loan with interest when your customer settles their accounts. The invoices serve as collateral.
Selective Invoice Finance
This solution allows you to choose specific invoices to finance, offering flexibility and control in how much working capital you have access to.
Advantages of Invoice Finance
1. Improved cash flow
Invoice finance gives you immediate control of otherwise tied up capital owed to your business.
2. No credit requirements
Your business does not need a stellar credit history to qualify for invoice finance.
3. Simple and easy
With some forms of invoice finance, you don’t even have to worry about debt collection. This frees up your resources for other business opportunities.
Disadvantages of Invoice Finance
1. Cost
Factoring fees can be higher than traditional loan interest rates.
2. Loss of control
With some forms of invoice finance, there is a loss of control over the debt collection process.
3. Customer impact
Depending on your customers and the form of invoice finance you opt for, there may be some hesitancy on behalf of customers to dealing with a factor.
A Guide to Letters of Credit
Letters of Credit are all about building trust in international trade.
A Letter of Credit is a guarantee issued by a financial institution, like a bank, on behalf of a buyer (in the case of international trade, an importer) to a seller (exporter).
It ensures that both parties have confidence that the other side of the trade will uphold their side of the agreement.
How does it work?
First, the buyer/importer’s chosen financial institution issues a Letter of Credit to the seller’s financial institution. This document also outlines the payment terms and conditions.
The seller is then confident that they will be paid and ships the goods to the buyer. It will also provide documentation proving compliance with the Letter of Credit. Once verified, the importer can release payment to the seller.
Types of Letters of Credit
Documentary Letter of Credit
This Letter of Credit outlines that payment is tied to specific documents proving shipment compliance. It is the most common type.
Standby Letter of Credit
A Standby Letter of Credit acts as a guarantee for non-performance. It is used to provide financial security if the seller breaches the contract.
Irrevocable Letter of Credit
This type of Letter of Credit cannot be canceled by the issuing financial institution once established and offers the highest level of security.
Advantages of Letters of Credit
1. Security for Both Parties
Letters of Credit offer a secure payment guarantee for both the buyer and seller on either side of the transaction.
2. Reduced Risk
With guarantee of payment and the provision of goods, there is a minimised risk of a breakdown in relations and trust in the international transaction.
3. Facilitates Trade
Letters of Credit enable and encourage international trade by building trust between parties, especially when establishing the relationship initially.
Disadvantages of Letters of Credit
1. Cost
Letter of Credit facilities involve fees for both the issuing and confirming financial institution.
2. Complexity
Depending on the requirements and process, the right Letter of Credit can be complex and time-consuming to set up.
3. Limited Flexibility
With strong risk minimisation, Letters of Credit require strict adherence for both the buyer and seller.
Choosing Invoice Finance vs. Letter of Credit
Which financial solution is right for your business? Here are some guiding questions to consider:
Is the Transaction Domestic or International?
If the transaction is domestic, you may want to consider invoice financing. For international business, Letters of Credit will be more suitable.
What is Your Credit History?
Invoice Finance suits businesses with all types of credit history whilst Letters of Credit may only be available for those with good credit history.
What’s the Risk Level of Your Customers?
High risk customers require security around payment in the form of Letters of Credit. While Invoice Finance is suited for customers with longer payment terms.
What is your Urgency for Cash Flow?
Invoice Finance offers fast and seamless access to working capital while Letters of Credit can take longer to establish.
What’s the Volume of Your Transactions?
Occasional transactions can be more cost effective with a Letter of Credit whilst Invoice Finance is more suitable for high volume of invoices or invoices of high value.
Call ScotPac today to find the right option for you
Ultimately, the best option depends on your business’s specific needs and circ*mstances.
That’s why, at ScotPac, we consult with our clients individually to understand their business objectives and tailor the right financial solution accordingly. To find out more or for an obligation and pressure-free initial consultation, contact our lending specialists today.
