How invoice finance works
To simply and clearly explain how invoice finance works, we will create a hypothetical scenario of a business called ABC Company. This business offers credit terms to its customers, allowing invoices to be paid in 30 days from the invoice date.
At one point in time, ABC Company has $500,000 in outstanding invoices. It needs to improve cash flow but doesn’t have property to use as collateral to get one of the secured business loans offered by banks. It approaches the bank or non-bank lender that offers invoice finance to get quicker access to the money it is owed.
The invoice lender provider checks that background of ABC Company, including years in business and annual turnover. ABC Company gives the lender access to the unpaid invoices. The lender analyses the invoices to determine the size and quality of the invoices. This can include a credit assessment of the debtors with outstanding invoices.
Based on the analysis, the lender agrees to loan ABC Company 80% of the value of the invoices, which is $400,000. It holds the remainder, $100,000, in reserve. The businesses owing the money on the invoices pay the lender or ABC Company, depending on the type of invoice finance. Once the lender receives all the money owed from the customers, it pays ABC Company the remaining $100,000, less a factoring fee which usually ranges between 2% and 3%. In this case, we will say it’s 2%, so the invoice finance company keeps $10,000 as a factoring fee.
Any funds not paid within an agreed period are withdrawn from the amount held in reserve, so ACB Company won’t receive money for invoices that go unpaid.
Various forms of invoice finance
There are several forms of invoice finance with variations on how it is carried out.
With invoice factoring, the lender takes control of the sales ledger with the outstanding debts. So ABC Company’s clients would be contacted by the lender and would be aware that collection has been outsourced. Factoring is usually used by smaller companies.
Confidential invoice financing or invoice discounting is where the borrower maintains control of the sales ledger and contacts customers to pay their invoice if they are late. This is usually used by larger companies that have receivables functions and departments in place.
Some factoring firms offer spot factoring where the borrowing company can choose which invoices to borrow against.
Pros of this form of finance
The biggest benefit is that it enables the borrower to get quick and easy access to the money they need. Invoice finance lenders are able to analyse invoices quickly and make a decision within a few days. Once approved, the funds are released within 24 hours.
Another benefit is that it doesn’t require property or other physical assets as collateral. It is a form of cash flow finance where the invoices are the collateral for the loan.
Cons of this form of finance
With invoice factoring, your clients know you have outsourced your invoices to another company because that company will contact them for payment. This might not be the image you want to portray to your clients. They could be asking. “Why have they outsourced my debt to another company that I am not familiar with?”
The interest rate can be high. If you are paying 2 to 3 percent to get you funds one month early, that equals 36% on an annual basis. This might be too high if you’re looking for a long-term business cash flow solution. Also, when invoices go beyond 30 days, you will continue to pay interest on the amounts outstanding.
In addition to interest, establishment, due diligence and service fees can apply to invoice finance. This is similar to other forms of business finance such as a line of credit. These additional costs need to be factored in to determine the true rate of interest you are paying for this type of funding.
Some lenders will only work with large dollar amounts. Westpac invoice finance, for example, has a minimum of $500,000 of total outstanding invoice amounts to use their invoice finance services. With Westpac invoice finance, you can access up to 85% of the value of your invoices, but most small businesses won’t have such a large total value of invoices outstanding.
Alternatives to invoice finance in Australia
Short-term unsecured business loans can be an alternative form of finance if you are planning to improve your business and grow. These are short-term and don’t require any collateral, including invoices. Advanced online lenders use leading-edge technology to analyse a company’s finances and make a lending decision. The process is fast. With Moula, for example, it takes around 10 minutes to complete the application and you will receive an answer within 24 hours. Once approved, the funds are transferred to your bank account immediately.
For an alternative to invoice financing, learn more about unsecured business loans from Moula.