An Entrepreneur’s Quick Guide to Invoice Financing for Small Businesses

If you’ve been in the business long enough, you’ll realize that companies experience capital shortages. Companies that have to wait for months to get paid are especially prone to cash flow issues. Fortunately, invoice financing lets business owners accelerate cash flow by selling their invoices to third-party companies. This way, they won’t have to wait for months for the customers to pay them.

In this article, we’ll outline what invoice financing is and discuss the different types available for small businesses. We’ve also gone ahead and laid out the pros and cons of this financing option.

What is Invoice Financing?

Invoice financing is a type of business funding wherein the business sells its outstanding invoices or account receivables (A/R) to financing companies to get an immediate cash flow boost. The financing company takes over the invoices, and sometimes be in charge of collecting customer payments (as in invoice factoring).

Invoice financing is a popular financing option for businesses that have to wait 30,60, or 90 days to get their clients’ payments. Most often than not, these businesses experience cash flow shortages, which can disrupt their day-to-day business operations. Industries like manufacturing, wholesale, transportation and freight, as well as staffing firms commonly make use of invoice financing.

With invoice financing, critical factors like credit history, credit score, financial background, and other pertinent financial information regarding your company won’t be the major consideration for approval. Instead, the lenders will look at the risk profile of your client and make the approval decision based on that.

Typically, the financing company can grant you 80% to 95% of the invoice value upfront. With this much capital on hand, businesses can put the money towards any business needs. It could be pursuing time-sensitive business opportunities, expansion, renovations, day-to-day expenses, or purchase inventory.

Types of Invoice Financing

Invoice factoring comes in five different forms. Business owners must know how each of them works in order for them to decide which one best fits their business current needs and situation.

Here are the five types of invoice financing:

1. Invoice Factoring
Invoice factoring is the most common type of invoice financing that businesses apply to. The business sells their invoices to the factoring company and receive money upfront. Not only will the company advance you the cash you need, but it will also handle the payment collections on your behalf.

It’s worth noting that since this is the case, your customers are more likely going to be aware that you’re working with a factoring company. On a positive note, you’ll be released of the responsibility of chasing and collecting the payment yourself, which is convenient especially if you don’t have the manpower nor the resources to do it.

Once the business’ (borrower) customers pay the invoices, the factoring company deducts the borrowed amount plus the fees, then returns the remaining money to the business.

Invoice factoring is further divided into two types: recourse and non-recourse factoring.

· Recourse Invoice Factoring
In recourse factoring, the borrower takes full responsibility of the invoices, should their customers fail to meet the payments. In other words, they will have to buy the invoices back from the factoring company using their reserve cash.

· Non-recourse Invoice Factoring
In non-recourse factoring, the financing company shoulders all the risks involved. This means that if the customers fail to pay the invoices, the factoring company will fully assume the losses. For that reason, factoring companies usually doesn’t offer non-recourse factoring, unless the borrowers’ customers are highly credible.

2. Invoice Discounting
For companies that prefer keeping their relationship with invoice financing companies a secret, invoice discounting or confidential invoice financing could be a more suitable funding choice. In invoice discounting, the business will take full responsibility of the payment collection.

Once the customers pay their outstanding invoices, the business pays the financing company with the amount they borrowed plus the charges associated with the funding service. Businesses with a good credit background (i.e., reliable and consistent payment history) and financials are usually the best candidates for invoice discounting.

Invoice discounting is more suitable for larger companies with the resources needed to conduct the payment collection themselves. Financing companies consider them as low-risk because they tend to have a credit-worthy and established customer base.

3. Selective Invoice Financing
Selective invoice financing is a more flexible type of invoice financing. While both invoice factoring and discounting may require you to sell all of your account receivables (A/R), with selective factoring, you can control which invoices you can sell and which ones you retain control over. The business owners can finance a single account receivable or multiple invoices in one transaction.

Most of the time, companies prefer selling their largest invoices to the financing company. This way, they won’t have to worry about large cash flow gaps. With selective invoice factoring, large invoices can go from being a high liability to a valuable asset.

4. Spot Factoring
Like selective invoice financing, spot factoring lets you sell a single invoice, instead of your entire account receivables ledger. It’s a viable funding solution for businesses who are looking to address a large but temporary cash flow gap or in instances where they need a large boost in their working capital.

In spot factoring, the businesses usually sell their largest invoice, which is usually worth thousands of dollars. The factoring company will also take charge of the payment collection. Once the customers pay the invoices, the company deducts the advanced amount plus the fees.

Business owners can expect the costs for spot factoring to be relatively higher compared to other types of invoice financing. The factoring company typically charges their clients with the control and convenience they offer.

5. Online Auction
In case you didn’t know, you can sell your invoices through online auctions, too. These days, you can find a lot of different things being auctioned online, including account receivables (A/R).

Online auctions offer a unique way of freeing up cash tied on your invoices. With an online auction, you can choose which invoices you want funded. Businesses can upload their invoices which will then be presented to investors and lenders. The party that offers the highest bid wins and gets full control of the account receivables.

Pros and Cons of Invoice Financing
Like other financing options, invoice financing has its set of pros and cons. First, let’s discuss the pros of invoice financing:

Pros

1. High Rate of Approval
Invoice financing companies are more interested with the customer’s credit and financial background, rather than the borrowers’. Before approval, lenders will do a background check on the customers, then decide whether they will approve the financing or not. By checking the customer’s backgrounds, the financing company will have a better picture of the risk they’re assuming.

So, if your major concern when taking out a loan is your company’s low credit score and or poor financial history, invoice factoring could be a viable funding option to consider. As long as your customers are financially stable and have a flawless payment history, you’ll have higher chances of getting approved for the financing.

2. Immediate Funding
Businesses applying for traditional loans would have to wait weeks or even months to get the approval. There isn’t even an assurance that they’ll end up getting the loan. With invoice financing, however, you can get approved within a matter of days. Some alternative lenders may even approve your loan after 24 hours and wire the money immediately.

It makes a suitable financing option for businesses looking to invest in a time-sensitive business opportunity, or those who are looking to meet their monthly payables.

3. No Need to Chase Customers for Payments
Chasing and collecting payments is one of the most challenging tasks for every business. You don’t want to look eager to your clients by bugging them for payments. Invoice financing companies can take this responsibility off your plate.

You can make use of invoice factoring to get the cash you need and at the same time let the factoring company handle the payment collection. With payment collection off your to-do list, you can use your extra time to deal with more pressing business matters, instead. It could be strategy planning, accounting, or getting more customers.

Cons

1. Higher Costs
With the ease and convenience of invoice financing also comes the high costs. Financing companies typically charge a service fee of 1 to 5 percent of the total amount of the invoices being funded. For some companies, this could be a major downside.

Before deciding to go with invoice factoring, consider whether the benefits the financing will bring your company outweighs the disadvantages.

2. Approval is Dependent on the Customer’s Credibility
Again, invoice companies decide on the approval based on your customers’ credibility. If the lending company finds that your customers have a questionable credit and payment history, it can hurt your odds of approval.

3. Liabilities
Depending on the agreement you and the financing company have agreed to, you could be liable for your customer’s unpaid invoices if they fail to pay within the allotted time frame, such as what happens during a recourse factoring. In this case, you would have to buy back the invoices. If you’re on a cash pinch, this could cause additional strain to your finances.

Final Thoughts
If you find yourself experiencing cash flow issues because of unpaid invoices, invoice financing is definitely a practical financing option to consider. You have five different options to choose from so whatever your company’s needs are, you’ll be sure to find the invoice financing option that best fits your company.

While there are some downsides, invoice financing can give you the quick cash you need, so you won’t have to deal with missed payments and growth opportunities again. As long as you have credible customers, you can take advantage of this financing option to see your business succeed.

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Author: Jake Eisenberg

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