It isn’t unusual for businesses to have irregular cash flows. But irregular cash flowscombined with limited cash reserves can create problems for both businesses and those whomanage them. Growing businesses, in particular, often face this simultaneous challenge,especially those in B2B sectors that rely on credit terms — meaning, customers mayhave 45, 60 or even 90 days to pay. In situations where stretched-out payment terms create acash crunch, companies sometimes look to invoice financing to turn their accountsreceivables into cash. Invoice financing can offer a good alternative to bank loans orcredit lines for companies that can’t readily access those more traditional forms ofcapital.
What Is Invoice Financing?
Invoice financing is an accounting method that letsbusinesses borrow against their accounts receivable to generate cash quickly. With invoicefinancing, a company uses an invoice or invoices as collateral to get a loan from afinancing company.
Invoice financing vs. invoice factoring: Invoice financing and invoicefactoring are two ways a business can generate cash from unpaid invoices. Invoice financingis similar to a traditional secured loan in that it has set payment terms and interestcharges accumulate on outstanding balances, but it uses one or more invoices as collateralfor the loan. In invoice factoring, the cash the business receives isn’t in the formof a loan. Rather, a factoring company, AKA a factor, actually “buys” theinvoice and assumes responsibility for its collection.
Key differences: While the benefits of invoice financing and invoicefactoring are equivalent — namely, the receipt of cash on receivables that are stilloutstanding — the two methods are structured very differently. The differences includehow the financing company charges for its service and which party pursues the customer forpayment.
| Invoice Financing | Invoice Factoring | |
|---|---|---|
| Invoice ownership | Business that creates the invoice continues to own it. | Factoring company that buys the invoice becomes its owner. |
| Invoice collection | Usually handled by the business that created it. | Usually handled by the factoring company. |
| Financial company’s fee | Financing company charges a percentage each week on the amount of cashadvanced, which is considered a loan. There is also often a processingfee. | Factoring company purchases the invoices for less than their actualdollar value. |
Key Takeaways
- Invoice financing allows businesses to borrow money against their pending accountsreceivable.
- Businesses typically opt for invoice financing when they are facing a cash shortage ortemporary cash-flow problem.
- Invoice financing is more expensive than traditional bank financing, but it requiressignificantly less paperwork and can usually be secured much quicker.
- Invoice financing makes most sense for businesses that have well-known customers who paytheir bills on time.
- It is not an option for B2C businesses; it’s only applicable in B2B sectors.
Invoice Financing Explained
Every company needs cash to fund its operations — to pay for materials, distribution,rent and payroll, to name just a few necessities. Companies with bank loans or lines ofcredit can take advantage of them during periods of slow cash flow.But companies that need cash quickly or can’t secure a traditional bank loan sometimesturn to receivables financing. In receivables financing, a financial company extends a loanto a business based on revenues earned but not yet collected. For some companies, the cashthey receive — often within a day or two of entering into a financing arrangement witha financial company — can provide essential liquidity until they have a morecomfortable cash cushion.
Invoice financing works best for B2B sellers that have well-known customers with a reliablepayment history. Retail, manufacturing and agriculture companies are among the types ofbusinesses that often turn to invoice financing as a financing mechanism. Invoice financingisn’t an option for companies that primarily sell to consumers or whose payment modelis cash-and-carry.
How Does Invoice Financing Work?
An invoice financing arrangement involves three parties: the business that issues an invoice,the customer that receives the invoice and the financial services company. To get themaximum benefit from this type of receivables financing, a business must negotiate termswith the financing company and hope that its customer pays by the due date on the invoice— or earlier.
The following chart captures the main steps in invoice financing.
How is invoice financing structured?
Invoice financing arrangements have some similarities to short-term loans. In its simplestform, invoice financing would be based on a single invoice, or account receivable. With thatinvoice serving as collateral, a financial company operating as the lender advances cash tothe business that owns the invoice. When the business gets paid, the business sends theoriginal loan amount back to the financial company, along with interest based on the lengthof time the loan has been outstanding.
How much does invoice financing cost?
Invoice financing is not an inexpensive way to raise capital. A financial company providingcash to a business under this arrangement will typically charge both a single-digitprocessing fee and a weekly factor fee, also in the single digits. Because of the weeklyassessment of the factor fee — so-called because such lenders are themselves known as“factors” — even a low factor fee can result in an annual percentage rate(APR) of 25%, 35%, 50% or even more.
To understand the economics, consider a hypothetical urban design firm looking to raise cashagainst a $50,000 invoice. A financial company agrees to advance the design firm 80% of theinvoice value, or $40,000. In return, the design firm will pay a 0.5% processing fee and a1.5% weekly factor fee on the cash outstanding. The design firm’s customer pays infour weeks, allowing the design firm to send the financial company the original $40,000 itborrowed plus the $200 processing fee and $2,400 it owes as a factor fee — or $2,600altogether. The design firm nets $47,400 of its $50,000 invoice.
Types of Receivables Financing
If a business has well-known customers with good credit, its accounts receivablescan be used to generate capital during periods of slow cash flow. There are three main typesof receivables financing:
Invoice financing. In this arrangement, a business goes to afinancial company to get a cash advance against one or more outstanding invoices.The cash advance can be for the full value of the invoice, though it is usuallysomewhat lower.
Invoice factoring. This is similar to invoice financing as a way tocollect on an invoice prior to its payment. In invoice factoring, however, afactoring company buys the invoice and takes responsibility for collecting paymentfrom the customer.
Receivables-based line of credit. This is a credit line thatbusinesses can get using their accounts receivable as collateral. The financialterms are often more favorable than the terms available through invoice financing orfactoring. In many cases, though, the dollar volume of invoices needed to obtain thecredit line is too high for smaller businesses.
Invoice factoring.
Invoice factoring is similar to invoice financing in that they’re both mechanisms forgetting cash quickly, and often the same financial companies will offer both kinds offinancing. However, in invoice factoring, the financial company actually buys the invoicefrom a business and takes responsibility for collection. This has the advantage of relievingbusinesses from time consuming collections efforts. That said, it also involves the risk ofceding control of an important customer interaction to a third party.
Accounts receivable line of credit.
This is another type of receivables financing that functions like a bank line of credit, butwith a business’s unpaid invoices serving as collateral. It can be set up so that thebusiness pays interest only on the money it borrows. AR lines of credit, however, can bedifficult to qualify for. Lenders usually require a relatively long-term commitment and asubstantial dollar volume of invoices, neither of which are typically options forearly-stage businesses.
Pros and Cons of Invoice Financing
Invoice financing can be immensely valuable to companies — allowing them to continueoperating during periods of constrained cash flow and to pursue potentially fortune-changingopportunities. But it also has some drawbacks. Management teams should understand both sidesbefore deciding whether to use invoice financing.
Pros: Invoice financing offers three main benefits that are especiallyhelpful for growing businesses, which may face certain challenges due to their early stageof development and limited resources.
Fast cash. In certain businesses, it is not unusual for companies tobe flying high from the perspective of sales and profit but struggling with cashflow. Invoice financing allows B2B companies to get advanced cash, sometimes within24 hours, on revenues they’ve earned but have not yet collected. In thesecirc*mstances, invoice financing can reduce an owner’s about cashflow andallow management teams to proceed with important initiatives that they wouldotherwise have to forgo.
Highly valuable in an emergency. Natural disasters that result indamaged inventory, a disruption involving a key supplier or the bankruptcy of a keycustomer — developments like these can quickly put companies in survival mode.If a business finds itself facing one of these existential threats and doesn’thave a lot of money in the bank, the rapid cash provided by invoice financing can becompany-saving.
Relatively light-touch approval processes. Many young and growingcompanies don’t have the necessary credit ratings to secure bank loans andlines of credit. This doesn’t matter as much to companies that provide invoicefinancing because they are more concerned about the credit rating of company’scustomers than about the business itself. A business applying for a cash advance onits invoices will typically face less paperwork and fewer questions.
Cons: Against these advantages, companies should consider the three maindisadvantages of invoice financing:
High cost. Invoice financing is a relatively expensive way to raisecapital. The processing fees and weekly interest, or factor, rates can result inAPRs that are multiples of what a business would ordinarily pay for a bank loan.
Unpredictability of ultimate cost. It isn’t just that invoicefinancing is more expensive than many traditional forms of finance. A relatedproblem is that when it enters into an invoice financing arrangement, a businessgenerally doesn’t know what its final cost will be. The ultimate cost oftendepends on how quickly a customer pays the invoice. A longer-than-contracted delayin payment can wipe out any profit from a sale.
Limited applicability. Not all businesses are able to use invoicefinancing. For its use to make sense, a business must be in a B2B sector. It mustalso have customers with excellent credit ratings and a history of paying on time.
Invoice Financing Example
It is the first day of the month, and Nippity-Doo-Dah, a hypothetical maker of winterapparel, has just fulfilled a $200,000 contract for finished clothes with a retail chain. Itis aware that the delay in payment — the retailer’s payment terms are 30 days— is going to leave Nippity-Doo-Dah short of cash for other operating needs. So, aftersending the invoice to the retail chain, Nippity-Doo-Dah’s next step is to approach acompany that occasionally finances its invoices.
The financing company says it can wire Nippity-Doo-Dah 80% of the invoice value, or $160,000.The processing fee for the loan is 2%, and the factor fee — similar to an interestrate — will be 1% a week until the invoice is paid. The retailer actually pays 21 daysafter receiving the invoice, meaning Nippity-Doo-Dah will pay 3% interest on the $160,000.Altogether, Nippity-Doo-Dah’s owner owes the financing company $8,000 — $3,200for processing plus $4,800 in interest. With the payment in hand, the apparel maker wires$168,000 to the financing company. After deducing financing charges from the invoice amount,Nippity-Doo-Dah brings in $192,000 from the retailer.
| Day 2 | Day 21 | Day 28 | ||
|---|---|---|---|---|
| What happens | Nippity-Doo-Dah receives 80% of the $200,000 invoice value from itsfinancing company. This is basically the principal on the short-termloan. | Nippity-Doo-Dah receives retailer's payment. | Nippity-Doo-Dah returns loan values to finance company, along with theprocessing fee and 3% total factor fee. | How much Nippity-Doo-Dah nets from the $200,000 order: $192,000 |
| Cash flow | +$160,000 | +$200,000 | -$168,000 | N/A |
How to Qualify for Invoice Financing
To qualify for invoice financing, a business should have accounts receivable fromcreditworthy customers that have a history of paying invoices promptly. A business shouldalso understand that its own credit score and business fundamentals will likely be lookedat, even if they aren’t the financing company’s main concern. An owner with apoor credit score might have trouble getting approval from certain financial companies. Inother cases, a low credit score will result in higher payments and fees.
How to Apply for Invoice Financing
The process begins with a business filling out an application, often online, and sharingdetails about the invoices it wants to finance. The businessperson who is handling theapplication will have to show some form of identification, which could be a driver’slicense. It is usually necessary for the company to submit other documentation as well, suchas avoided business check, bank statement or financial statements.
Automate Invoice Financing With NetSuite
NetSuite’s Cash 360 dashboard automates cashflow forecasting and gives companies a better understanding of their near-term cashrequirements and how much they're likely to collect. This helps inform decisions, such aswhether invoice factoring is required or not. In addition, NetSuite’s embedded SuiteBanking solution gives customers access to avariety of financial services from within NetSuite, allowing them to choose which ones towork with, what information they’ll share, and track the status of their accountswithout leaving the application.
Conclusion
Many B2B businesses go through periods of irregular cash flow, especially if they have slowpaying customers or offer extended payment terms. Companies that are in this situation anddon’t have a flush bank account sometimes end up cash-constrained. If they don’thave access to traditional bank loans or lines of credit, invoice financing can be a goodsolution. In invoice financing, a company that needs cash fast uses some of its invoices ascollateral to secure additional capital from a company that provides short-term financing.Although invoice financing is a relatively expensive way of raising cash, it is often usedby growing businesses to cover near-term operating expenses or pursue growth opportunities.
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Invoice Financing FAQs
Is invoice financing a good idea?
Invoice financing can make sense for companies experiencing a temporary cash flow shortfall.It is more expensive than traditional bank financing and is thus most often used bybusinesses that don’t have access to bank financing in the amounts they need.
What is sales invoice financing?
Sales invoice financing is a form of accounts receivable financing. It describes anarrangement in which B2B companies use their unpaid invoices as collateral to borrow moneyfrom financial companies.
What is the difference between invoice financing and factoring?
Both are ways to raise cash quickly using unpaid invoices. In invoice financing, thefinancial company basically acts as a lender, advancing money to a business while treatingthe unpaid invoice as collateral. In invoice factoring, the financial company actually buysthe invoice and assumes responsibility for collecting on it.
