What is invoice finance?
First, if you’re not familiar with the concept, it’s a form of business lending where you receive funds in advance based on the value of your outstanding invoices. The debtor finance company will look at a company’s debtor ledger and conduct due diligence to ensure that the businesses can pay their invoices. Once the invoices have been reviewed, the finance company will advance a percentage of the total amount of the invoices, usually 80 per cent, to the small business needing funding. When the invoices have been paid, the finance company will pay the remaining amount, less fees and interest. For more details on how it works, see What Is Invoice Finance?
How does invoice finance differ from invoice factoring?
With invoice finance, you maintain control over the management of invoices and collections. With invoice factoring, the lender will take over the invoices and contact customers directly for payment. So the customers will know that you have outsourced the debt to an outside business, which are known as factoring companies.Many people now use ‘invoice finance’ as a blanket term to cover invoice factoring as well.
Now let’s examine the factors that determine the true cost of invoice finance.
Discount fee or interest fee
While the invoices are outstanding, the finance company will charge what’s called a discount fee, interest fee or factoring fee. This is one of the main invoice finance costs. A typical discount rate (interest rate) for accounts receivable finance is 10 per cent per annum. This cost will depend on a number of factors, including the creditworthiness of the debtors.
This is in addition to the interest charged on the total dollar amount of invoices. Typical rates are between 1 and 3 per cent. This fee will be the same regardless of how long customers take to pay their invoices. For example, if the invoices total $100,000 and the service fee is 2 per cent, then this fee will be $2,000.
Due diligence fee
This is the amount the invoice financing company will charge for analyzing the invoices to be lent against. It is a flat fee based on how much time the lender thinks it will take to conduct due diligence. These companies want to know the types of businesses and their financial positions before the advance money based on the invoices. They could reject invoices that seem too risky.
This is the percentage of the total invoice amount you receive up front. It’s typically 80%. For example, if the total value of invoices is $100,000, the funder will advance $80,000. The remainder (less interest and fees) will be paid to the business after the invoices have been paid by the customers.
Adding up the cost of invoice financing
Here’s a hypothetical example of the cost of using invoice finance. Let’s say a business wants to get funds early and has an outstanding invoice amount of $100,000.
With an advance rate of 80 per cent, the business will get $80,000 upfront.
The finance company charges a service fee of 2 per cent, which is $2,000.
The interest rate (discount rate) is 10 per cent per annum. If half of the invoices are paid in 30 days and the remainder are paid in 60 days, the interest cost will be:
($80,000 x 10%) x (30/365 days) + ($40,000 x 10%) x (30/365 days) = $987
In addition, we’ll say the due diligence fee is $500 for that batch of invoices and add that in.
So the total cost of invoice finance is $2,000 + $987 + $500, which equals $3,487.
That’s 4.4 per cent over two months ($3,487/$80,000). On an annualised basis, the interest rate is 26.4 per cent. This is more than double the amount of the 10 per cent interest rate when you factor in all the costs.
In addition to these, hidden invoice finance costs can include:
- Establishment fee to put the facility in place
- Annual management fees
- Bad debt insurance protection
- Early exit fee
- Minimum use/non-utilisation fee
- Quarterly audit charge.
So the invoice finance cost could much higher when you add up all the hidden expenses.
What are the alternatives to invoice finance?
While invoice finance could be a solution for some businesses, it’s not suitable for all, especially with its high cost. Alternatives can include a short-term business loans and business lines of credit.
Moula Pay is another option for financing business-to-business transactions. With Moula Pay, the approved merchant gets funds immediately after making a sale. The customer gets a three-month interest-free and repayment-free period. After this, there is an additional nine months to repay the transaction amount. As a cash flow solution for both merchants and purchases, Moula Pay creates a win-win outcome.
Learn more about the benefits of Moula Pay.