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Invoice Financing – What Is It and How Does It Work?

January 25, 2022

What is Invoice Financing?

Invoice financing is a collective term for lending based on outstanding invoices. It’s also known as ‘invoice factoring’, ‘invoice discounting’, ‘debt factoring’, ‘accounts receivable financing’, ‘trade finance’ and sometimes just ‘factoring’.

Invoice factoring can be used by both suppliers and buyers (this is known as ‘reverse factoring’ – see more below) but in the following article we’ll concentrate on examples using suppliers.

Invoice financing allows suppliers to improve cash flow by selling outstanding invoices to a third-party ‘finance provider’. (The finance provider is also known as an ‘invoice factor’ and in this article we’ll use both terms.)

The finance provider then pays the supplier an initial amount (e.g. 90%) of the outstanding invoice and may also (depending on the type of invoice finance used) take on responsibility for chasing the debtor for payment.

Once the invoice is settled in full, the finance provider passes on the remaining money (10% in the above case) to the business, minus a small fee.

Example:  ABC Supplier Ltd is owed £10,000 by XYZ Buyer Ltd and invoices them for payment with 90-day terms. However, ABC Supplier needs cash now. So, it sells the invoice to an invoice financing company (Financer Ltd) that pays 90% of its value (£9,000) to ABC Supplier within 48-hours of the relevant documents being signed.

Financer Ltd now owns the invoice, including the responsibility for chasing XYZ Buyer for payment. When the buyer pays the full £10,000 invoice to Financer Ltd, Financer will then pay the remaining £1,000 to ABC Supplier, minus a pre-agreed service charge. In this case, Financer Ltd also offers non-payment protection, so ABC Supplier is covered if XYZ Buyer is unable to pay.

Invoice financing is useful for businesses of all sizes but is increasingly being used by companies expanding into international markets, where caution regarding new buyers may be a sensible approach. Selling invoices can enable businesses to free up the capital for larger projects as well as protecting themselves against non-payment in new trade deals.

 

A Closer Look at the Process

How suppliers use invoice factoring for short-term funds.

How suppliers use invoice factoring for short-term funds.

  • A supplier invoices a buyer or client for its product or service, let’s say with payment terms of 120 days.
  • However, the supplier needs cash now, so applies for invoice financing with a finance provider. Some fast providers can review and approve such applications in as little as 15 minutes.
  • The finance provider accepts the application and pays the supplier 90% of the outstanding invoice to give it the cash it needs.
  • The finance provider takes payment later from the buyer.
  • When the buyer pays in full, the finance provider pays the remaining 10% (less a pre-agreed fee) to the supplier. 

 

Who Uses Invoice Financing?

The simple answer is… lots of companies all around the world.

Among UK companies with a turnover exceeding £1 million, around 1 in 5 of them currently use some form of invoice discounting (more on ‘invoice discounting’ below) to boost cash flow. Invoice financing currently stands at around £22 billion per year in the UK.

Including the UK, European countries account for 68% of global factoring volume, with France, Germany, Italy and Spain all being key players.

Asia accounts for a further quarter of the global invoice financing market, worth €697 billion. Most of this is transacted within Greater China (Mainland China, Hong Kong and Taiwan).

South America and Central America currently transact a volume of around €84 billion in factored invoices, their key players being Chile, Brazil, Mexico and Peru.

Africa is one of the fastest-growing factoring markets, currently accounting for €25 billion in funding.

These figures stand before a background of global trade in which an estimated $17 trillion (USD) worth of invoices are eligible for financing, meaning that many other businesses – both suppliers and buyers – can take advantage of the benefits that invoice financing offers.

Invoice financing is used by all industries but commonly includes businesses that specialise in consumer goods (clothing, automotive, electronics, food and manufacturing) as well as service suppliers (often software and consultancy firms).

 

Invoice Discounting vs. Other Forms of Financing

‘Invoice discounting’ is a form of invoice financing that comes with a key difference.

As with other forms, the finance provider pays part of an outstanding invoice to free up cash to supply short-term cash needs, but with invoice discounting the supplier retains full control of the invoice and is therefore responsible for chasing later payment from the buyer.

When the invoice has been paid in full by the buyer, a small fee is then claimed by the finance provider.

However, the supplier will have no protection should the buyer fail to settle the invoice. In such a case, the supplier will be liable to reimburse the finance provider for the original money that was advanced. Invoice financing of this kind is known as ‘recourse financing’ (see more below).

It is worth noting that because the supplier retains full control of the invoice, the buyer won’t know that the supplier is using a finance provider.

 

Different Types of Invoice Financing

Different types of financing arrangements offer different benefits to businesses:

  • Recourse financing: As mentioned above in ‘Invoice Discounting’, this is where the supplier assumes the risk for payments from its buyers. It will be liable to pay back the invoice amount to the finance provider if the buyer cannot pay. By taking on this risk for itself, the business is typically able to secure lower fees from the lender.
  • Non-recourse financing: In this case, the finance provider assumes the full risk for non-payment from the buyer. If the buyer can’t pay, the lender will be facing total loss and will be responsible for legal costs in trying to recoup that loss. The supplier will retain all money paid to it for the invoice and can spend without concern for future developments. If a company wants this type of protection against non-payment, it should seek non-recourse financing.
  • Domestic and cross-border financing: Domestic financing simply refers to deals where all parties are based in the same territory. Cross-border financing describes a deal where the supplier and buyer operate in different international markets. Cross-border financing fuels a large part of international trade.
  • Disclosed and undisclosed financing: ‘Disclosed’ and ‘undisclosed’ financing refers to whether or not the buyer knows that the supplier is using an invoice financing provider.

Is Invoice Factoring Better Than a Loan?

Invoice financing is often used as a way of accessing short-term credit instead of applying for a business bank loan. Invoice financing and bank loans offer many similar benefits but invoice financing can provide some additional advantages/benefits: 

  • Both forms of financing allow a business to spend funds on any business expense it needs to, with fixed charges agreed up-front, but invoice financing carries less risk. Because a company isn’t accessing any funds that aren’t already owed to it, there is much less chance of it being unable to meet repayments. N.B. with non-recourse financing (see explanation above) there is no risk at all!
  • Unlike business loans, there are no long-term repayment schedules and no risk of damaging the firm’s credit rating.
  • Small businesses are more likely to qualify for invoice financing than for a traditional bank loan, because banks are often reluctant to take on the risk associated with lending to small businesses, particularly those involved in international trade.
  • Applying for invoice financing is typically quicker and more convenient than applying for a bank loan. There is usually much less paperwork.

 

Invoice Factoring – Advantages and Disadvantages

It’s important to understand the pros and cons of invoice financing compared with alternative financing options.

The Advantages of Invoice Financing

  • Instant cash flow: Invoice factoring companies typically review applications and deposit funds faster than banks will. High-tech finance providers can review applications in as little as 15 minutes and can make payments to successful applicants within 48-hours. This makes invoice financing ideal for businesses with short-term financing needs. 
  • Greater chance of approval compared with bank lending: Banks are often unwilling to risk lending money to small businesses, especially for international trade where the risk of non-payment may be higher. However, invoice factors are advancing funds against an invoice for which funds are due, so there is a greater chance of applicants getting approval.
  • However, invoice financing is not a quick fix. Applicants will still need to meet certain criteria to qualify for cash and will be reviewed differently according to whether they are suppliers or buyers. They’ll be assessed on how much financing they want and will be asked for financial statements. They will also need to be in good standing and will certainly be assessed differently if they are just starting out (i.e. they have no track record of trading volume) or are involved in bankruptcy or litigation.
  • Delegating invoice chasing: If the applicant applies for non-recourse financing, the finance provider will own the invoice and the risk. It will be their responsibility to chase late payment and to suffer the loss if the invoice is never settled. This is especially attractive for smaller businesses, particularly if they lack the time and resources to do it themselves.
  • No collateral needed: Unlike bank loans, invoice factoring doesn’t require businesses to put up any collateral or deposit. Instead, the invoice acts as the deposit.
  • Opportunity for growth: Invoice financing gives growing businesses access to immediate funds for new staff, equipment, marketing and even the acquisition of new clients. They will not have to suffer delays of up to 120 days for payments and the cash-flow fluctuations that go with them. It can also provide a route into international trading with less risk for companies that wish to break into the market.

The Disadvantages of Invoice Financing

  • Invoice financing costs: Invoice factoring companies charge a small fee for their services. Generally, you can discover this fee by using the financing calculators which companies often publish on their websites.
  • Letting go of control: With non-recourse factoring, companies buy outstanding invoices from the business. This means they take control of collecting payment (thereby eliminating that risk for the supplier) but it will mean that the buyer will learn that the supplier is using a finance provider.
  • The business may be liable for repayment: With recourse factoring, invoice financing companies will require the supplier to buy back the invoice if the buyer doesn’t pay it. Those seeking invoice financing will need to decide if they want non-recourse factoring (no risk if buyer doesn’t pay) or recourse factoring (repayment of finance if the buyer doesn’t pay).

 

You can find more information about invoice financing in our FAQ section and the videos available here

If you have specific questions about your own business, you can contact us here

 

About the Authors

Stenn is a registered member of the ITFA, IFA and WOA. It has financed invoices worth over $7 billion (USD) to date and provides:

  • An online platform for easy applications.
  • Non-recourse factoring (i.e. full protection against non-payment of invoices).
  • Rapid assessments (usually within 15 minutes).
  • Cash advances within 48 hours, with only two documents to sign.
  • Advances of between $10K (USD) to $10M (USD).
  • Fees that begin at 0.65%.
  • Advances on international deals that other companies and banks can’t, or won’t, finance.
  • Services in 74 countries.
  • Reverse factoring (buyers can pay immediately and settle the invoice later with us).

This article is authored by the Stenn research team and is part of our educational series. © 2021 Stenn International Ltd. All rights reserved. Any redistribution or reproduction of part or all of the contents in any form is prohibited other than the following:

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Disclaimer: The above article has been prepared on the basis of Stenn’s understanding of current invoice factoring. It is for information only and doesn’t constitute advice or recommendation. Whilst every care has been taken in preparing this article, we cannot guarantee that inaccuracies will not occur. Stenn International Ltd. will not be held responsible for any loss, damage or inconvenience caused as a result of anything published above. All those applying for credit should seek professional advice when doing so.