Invoice Finance: Are Unpaid Invoices Worth the Effort?
Outstanding invoices have a way of slowing down your cash flow. To make sure that you have the working capital you need to grow your small business, you might be considering the benefits of invoice finance. Learn more about this way of dealing with your accounts receivables and determine whether invoice finance is right for your business.
What Is Invoice Finance?
Invoice finance is a type of finance that provides you with working capital while you wait for your clients to pay their invoices. In business, it’s natural to offer invoices on net 30 or net 60 terms, but waiting to receive payments can make it harder to take care of the daily business of growing your company.
There are two main types of invoice finance, however, due to increasing competition lenders are constantly trying to come up with new and innovative ways to offer this form of receivable finance to their customers. Essentially, invoice finance is the act of borrowing money against one or more of your invoices. In exchange for the advance, the invoice is assigned to the lender as a form of security, often in addition to some other form of security such as a debenture or PG.
How Does Invoice Finance Work?
Imagine that you have a big project coming up that will require significantly greater resources than you currently have at your disposal. You might need to buy a lot of materials or hire new staff. While you have several outstanding invoices, you don’t have the cash right now to cover the costs of your new project.
In search of the funds you’ll need to grow your business, you reach out to a financial institution that offers invoice finance. The invoice finance lender asks for a copy of your invoice, providing works have been completed or product delivered, the invoice finance lender will advance you a percentage of the invoice value up front.
Most financial institutions don’t provide you with the full amount listed on your sales ledger. Instead, they commonly provide between 70% and 85% of the funds you’re owed. When your client pays the invoice, you will receive the remainder of the invoice value minus service fees. If you take a slightly different approach, you may be able to get up to 95% of the invoice value up front, but you’ll still have to pay service fees to the business finance institution.
Types of Invoice Finance
There are two major forms of invoice finance. In addition, there are different ways that you can use these finance solutions to meet your business needs:
1. Invoice Factoring
Invoice factoring is the most common form of invoice financing. With this type of financing, you sell your invoices to the bank, and they take care of receiving payment and pursuing bad debts. This type of financing frees you up to pursue your business goals without having to worry about late payments, but invoice factoring has its downsides.
Depending on the deal you make with your financial institution, you may only be able to access as little as 70% of the invoice value before it is paid. Once the client makes a payment, you’ll receive the remainder to the invoice value, but your factoring company will still deduct fees.
Lending institutions always provide financing based on risk. Since your financial institution will take total control over your invoices if you pursue invoice factoring, they will see this approach as being low-risk. Therefore, factoring is the right approach for a business that doesn’t have a significant lending history or has only been around for a few months.
2. Invoice Discounting
Invoice discounting provides you with much more of your invoice value up front. Depending on the agreement you make with your financial institution, you may be able to get as much as 95% of your invoice value in exchange for selling your invoices. Like all business loans, however, lenders provide invoice discounting based on risk, and financial institutions generally only provide invoice discounting to established companies.
Financial institutions don’t take control over your invoices when you pursue invoice discounting even though they own them. For this reason, invoice discounting is sometimes called “confidential invoice discounting” since your clients won’t know that you’ve pursued this type of invoice finance.
Retaining control over your invoices can be beneficial at a certain stage of business growth, but keep in mind that you’ll remain responsible for dealing with bad debt and late payments if you choose invoice discounting over invoice factoring. Only pursue this type of financing if you have the resources to handle all of your accounts receivable needs.
3. Selective Invoice Finance
In most cases, invoice finance covers all your invoices. However, you can also sometimes pursue selective invoice finance, which only provides you with working capital for one invoice. This type of invoice financing is sometimes called single invoice finance or spot factoring, and it’s ideal if you know exactly how much working capital you need to improve your cash flow at a given time and don’t want to give over total control of your invoices to a financial institution.
Selective invoice finance gives financial institutions control over a single customer account. If you know that a client might have trouble making payments but you want to work with them anyway, you may want to give control of that account to a financial institution as part of an invoice factoring agreement to ensure you receive bad debt protection. Spot invoice finance is when you make a deal with a financial institution to cover a single invoice.
What Is Credit Control?
Credit control is the process of vetting clients in terms of their creditworthiness. Your ability to practice good credit control will protect you from getting burned by bad clients who pay late or don’t pay at all.
However, handling credit control without the help of a financial institution can be too taxing for small businesses and large limited companies alike. One of the benefits of invoice finance is giving over responsibility for credit control to financial institutions, which generally have vastly superior collection mechanisms as compared to individual businesses.
If you decide to handle credit control without the help of a financial institution, you’ll need to develop a comprehensive credit policy that covers all the intricacies of your credit terms. Some components of a good credit policy include:
1. Credit Period
You’ll need to determine a standard credit period before you start invoicing customers. Many businesses choose a 30-day credit period, but you might prefer a seven-day credit period or even a 60-day credit period depending on your needs and the needs of your clients.
2. Collection Policy
Don’t wait to determine your collection policy until you have problems collecting late payment. Having a uniform approach to collecting bad debts will keep you from offending clients and protect you from the dangers of non-payment. Determine ahead of time how aggressive or passive you will be in the face of late invoices.
3. Credit Standards
Your credit standards can protect you from being burned by clients who aren’t creditworthy. If you lower your credit standards, you’ll be able to offer invoice finance to more clients, but higher credit standards help you ensure that you won’t accumulate bad debts or problems with nonpayment.
If you decide to pursue invoice discounting, make sure that you follow the same “Five C’s” of credit analysis that banks use to determine if a client is worthy of credit:
- Character: Sometimes you can learn everything you need to know about a client from his or her behaviour.
- Cash Flow: Make sure that a client has sufficient capacity to pay back debts before you offer credit.
- Capital: Does your client’s business have enough value to handle its invoice debt?
- Conditions: Assess the effects that endogenous (within the company) and exogenous (outside the company) conditions will have on your client’s debt repayment abilities.
- Collateral: What can you hold over your client’s head to ensure payment?
Pros and Cons of Invoice Financing
Invoice financing is undeniably convenient, but there are some detractors to this approach to doing business that you should keep in mind.
- Gives you the funds you need to grow your business now
- Having a financial institution take care of receiving payments and pursuing bad debts frees up your resources to grow your business
- Invoice discounting gives you the freedom to grow your business without giving control of your company’s operations to a bank
- Invoice discounting gives you working capital without letting your customers know that you’re financing your invoices
- Like all financial services, banks charge fees for invoice finance
- Invoice finance doesn’t provide you with the full value of your invoice
- Invoice finance adds another layer to the already complicated process of invoicing customers
- An invoice discounting agreement will fall apart if your client doesn’t pay
- You are 100% responsible for credit control when you choose invoice discounting
How Do You Pick the Right Type of Invoice Finance?
In some cases, this decision may be made for you. Most financial institutions will refuse to offer invoice factoring to companies that aren’t fully established. If you have the choice between invoice factoring and invoice discounting, however, you’ll need to consider a few factors.
Invoice factoring is the easiest way to pursue invoice finance. No matter how big your company is, offloading credit control, accounts payable, and every other aspect of invoicing your customers to an external entity allows you to receive capital from your customers with hardly any effort on your end. Larger businesses can actually benefit from invoice factoring the most; the fees that banks charge for invoice factoring per invoice may end up being less than you’d pay to set up an entire accounts payable department.
Invoice discounting, however, works best if you don’t mind putting in the effort to chase down bad debts and perform the other tasks associated with invoicing your customers directly. This type of invoice finance provides you with a significantly larger chunk of your invoice value up front, which means that it gives you more working capital to throw around as you grow your business.
If you normally don’t need to finance your invoices, however, selective invoice finance is the right choice for you. Every business will eventually come across a situation where having some extra cash flow could be useful, and understanding the intricacies of selective invoice finance will prepare you for this eventuality even if you don’t want to pursue invoice finance as your main method of collecting debts from clients.
CreditDigital and Invoice Finance
CreditDigital offers an alternative to invoice finance that gives you the entire value of your invoice up front. By leveraging the latest technological developments and advances in finance, CreditDigital surpasses the restrictions that limit the ability of traditional financial institutions to give you the cash flow you need when you need it the most.
Like the invoice factoring services offered by banks, CreditDigital takes care of the hard work of credit analysis for you. When you invoice your customer with CreditDigital, they will be approved instantly, and you’ll be paid as soon as your customer selects a payment plan.
CreditDigital provides your customers with flexible payment plans that aren’t available with traditional invoice finance. While banks withhold a portion of your invoice value until your customer pays, CreditDigital provides you with your full invoice value immediately.
Unlike traditional financial institutions, CreditDigital is compatible with e-commerce transactions, offers zero percent interest options to customers, and doesn’t have any hidden costs. CreditDigital is easy to set up, and using this platform doesn’t involve any complicated contracts.
There are a few terms related to invoice finance that you might encounter as you learn more about this business finance option:
Invoice finance is essentially a form of asset-based lending since it involves selling your invoices to a financial institution. However, asset-based lending refers to any type of financing you receive in exchange for a form of collateral. For instance, some banks accept inventory and equipment as collateral for financing.
Your borrowing base is the amount of money a bank will lend you based on the collateral you provide. When you pursue invoice factoring, for instance, your borrowing base is usually 70-85 percent of the invoice value.
Collateralisation is when you pledge something of value in exchange for receiving a form of financing. In invoice finance, for instance, you “collateralise” your invoice or invoices to receive cash up front.