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What is invoice financing?

What is invoice financing?

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If you’ve ever relied on a customer’s invoice to get you through your business costs, then there’s good news: With invoice financing, you can turn those unpaid invoices into a cash-generating machine so that you’re never left without cash for your business. We’ll dive into what you need to know about invoice financing, including what it is, why you might use it, and its advantages and drawbacks.

What is invoice financing?

Invoice financing is a short-term business financing arrangement that provides business owners cash that is structured as a loan or a line of credit. When you are accepted, the invoice financing company uses your accounts receivable as collateral, which is why it’s also called accounts receivable financing.

Here’s how it works: An invoice financing company advances you a percentage of the invoice value in exchange for a small fee. You still own the invoice and have to collect payment for it, but you’ll receive the money you need in the meantime.

Invoice factoring is like getting an advance for your unpaid customer invoices.

Businesses rely on accounts receivable financing to generate cash quickly while waiting for clients and customers to pay their unpaid invoices. In turn, this cash gives the business enough working capital, whether they need to manage payroll, buy inventory, pay vendors, or pay a bill.

What’s the difference between invoice financing and invoice factoring?

Invoice financing and invoice factoring let you use unpaid invoices to generate quick cash, making them useful if your working capital is low as you wait for more money to come in.

But invoice financing and invoice factoring are not the same. For starters, invoice factoring is not a loan. It’s a financial agreement that businesses make with invoice factoring companies.

Like invoice financing, lenders give you a cash advance worth a percentage of your outstanding invoices. The difference is when your customer pays, the invoice factoring company forwards your remaining balance minus their fees.

Instead of maintaining ownership, your business sells your customer invoices to the lending company. In turn, the invoice factoring company has access to your business bank statements, can assess your customers’ credit history, is responsible for collecting payment from your customers, and may charge higher fees since there’s a more significant risk.

Why you might need to use invoice financing

When you’re waiting on customers to pay for their outstanding invoices, you’re only left with the cash in your bank to pay the bills.

This can be problematic: Nearly 60% of small business owners in the United States have less than $5,000 set aside for potential financial crises. So if you’re one of the many small business owners who don’t have thousands stacked aside, you’ll have to find another way to pay off these short-term obligations, like using a credit card.

But you don’t want to rely on your credit cards too much: If you don’t pay off your balance every month, you’ll incur extra interest expenses. That’s why invoice financing is a great alternative option.

Invoice financing is an excellent fit for B2B (business-to-business): B2B generally has higher-value invoices than B2C (business-to-consumer) with longer payment terms. Since more money is on the line and there’s a longer wait period, it makes more sense to apply for a loan or credit line makes more sense.

How does invoice financing work?

Invoice financing services can save your business in a pinch because you can access working capital quickly. Here’s how invoice financing works:

Chart showing the four steps to invoice financing

  1. Your business sends your client an invoice for your products or services. The invoice has a set due date of 30 days or more, so you don’t expect to receive the amount owed for weeks.
  2. You realize you need cash immediately to fund your operations, so you contact an invoice financing company and request an invoice loan.
  3. Your lender advances you a percentage of the invoice, usually between 70% and 85%.
  4. Your client pays the invoice by the 30-day due date, and you pay back the lender for the loan plus any agreed-upon fees. 

Let’s look at a real-life example of when a small business owner might decide to use invoice financing.

An example of invoice financing

Kay’s Catering hosted a corporate event for their client, Mega Software Solutions, and sent an invoice for $20,000 with a 30-day payment term. The next day, another client reaches out and wants Kay’s Catering to cater a birthday party last minute. But until Mega Software Solutions pays their invoice, Kay’s Catering doesn’t have enough cash to hire extra cooks and servers required for that event.

Instead of applying for a loan or charging more to the business card, Kay’s Catering turns to an invoice financing company. The invoice financing company agrees to lend Kay’s Catering 80% of the $20,000 invoice they’re waiting on with a 4% interest fee for every 30 days the loan is unpaid. This gives Kay’s Catering $16,000 as a lump sum, allowing the business owners to pay for the food supplies, labor, and cooking equipment they need for the birthday party.

After catering the birthday party, Mega Software Solutions pays its $20,000 invoice. Then Kay’s Catering successfully pays back the invoice financing company the $16,000 advance and $800 invoice financing and processing fee.

In the end, Kay’s Catering kept 96% of its original invoice amount ($19,200).

Pros of invoice financing

The advantages of invoice financing include:

  • You can lessen cash flow issues. Knowing this financing option is available enables your business to take advantage of opportunities you couldn’t otherwise afford.
  • Receive fast funding with ease. Unlike other types of financing, like a term loan, you’ll get the money quickly with invoice financing. There’s less paperwork and less waiting.
  • It’s easy to qualify for invoice financing. Because you’re using invoices as collateral, even small businesses with bad credit can qualify.

Cons of invoice financing

The disadvantages of invoice financing include:

  • Invoice financing cost is higher than other options. You might only be paying 1% to 5% per month for an invoice loan — but if you don’t pay it off within a year, the annual percentage rate is much higher than typical interest rates for bank loans or lines of credit.
  • Your costs depend on client payments. If your client is late, you’ll pay more in interest. For example, if you’re paying 3% per month on a $10,000 invoice, at 90 days, you’re paying close to $1,000 for the advance. That’s a steep charge for such a small loan.

Improve cash flow and your accounts receivable process with BILL

By now, you understand that invoice financing can help with short-term cash flow problems as you wait for customers to pay their invoices. But how do you know if invoice financing will work for your situation? First, you need to identify some main factors:

  • When your clients typically pay
  • What your cash flow needs are in the short term
  • If there are other ways to increase your working capital

Fortunately, with an accounts receivable system that tracks all your invoices, you can spot trends in client payments, predict when your receivables will come, estimate how much an invoice loan will cost you, and decide the benefit of having that money upfront is worth the cost.

Find out how AR automation software can improve invoicing and help you get more out of your receivables. Get started with BILL today.

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