Invoice financing is one of the most popular forms of commercial finance in the UK, yet it remains a mystery to many people.
So what is it – and is it something that could help you?
As with many things in the world of finance, once you’ve cut through the jargon, you’re halfway to understanding it.
Put simply, it is a line of credit issued against outstanding invoices. It can be a useful way to generate cashflow while you are waiting for your customers to pay you.
Let’s say you run an employment agency and you have a dozen temps working at a supermarket’s head office. You must pay those temps every Friday – but the problem is that the supermarket pays the invoices that you submit on a 60-day term. There’s little doubt you’ll get paid eventually, but you don’t always have the ready cash to pay all your temps every Friday.
That’s where invoice financing can come into play. You receive payment from a third party (typically between 80% and 90% of the total value of the invoice) up front, and the invoice-financing provider then collects the money from the supermarket. That will give you enough ready cash to meet your liabilities, and the finance provider then pays you the balance (less its charges) once it has received payment from the supermarket.
Jeff Longhurst, chief executive of industry body the Asset-Based Finance Association, said: “The reason the invoice-financing provider keeps a little bit back is because the advance is not paid on a single invoice but across the whole of the business’s sales ledger.
“You might have 20 or 30 customers, so the security that the finance provider has is between 10% and 20% of all the outstanding invoices. That means that if one customer fails to pay, the finance provider can recover the shortfall from the percentage it holds from across the range of customers.”
He added: “Invoice finance is all about providing the working capital and cashflow to help businesses grow. It isn’t a loan. The finance provider basically buys the debt, but it’s not like a debt collector where the expectation is that the customer won’t pay – it is just that they will take a few weeks before they do. We’re just oiling the wheels and bridging the cashflow gap.”
In the example above, the customer (in this case the supermarket) is instructed to pay the finance provider instead of the supplier.
There is full disclosure of the whole process, and often the finance provider will provide bad-debt cover, too. If you’re an owner-manager and you want to concentrate on selling rather than chasing up payments, you can just get on with the day-to-day running of your business safe in the knowledge that someone else is focusing on getting your cash in.
But many businesses don’t want to lose control of their ledgers, and they don’t want their customers to know that they’ve sold on the debt, so they might prefer an alternative invoice-financing product called “discounting”.
This works in exactly the same way but is confidential. The business still gets payment up front from the finance provider, but the business remains responsible for collecting payment from the customer.
Why might a business want such an arrangement to remain confidential? Well, because factoring is such a relatively safe way of providing funding as far as the finance provider is concerned, a factoring provider can step in and provide a facility to help a business that is in trouble.
“Although designed primarily for growing businesses, even if a business has had some sort of lost its biggest customer or has had a financial hiccup, an invoice-financing provider can nevertheless go in and provide funding against their debtors to help them trade through their difficulties,” said Mr Longhurst.
“The asset is of good quality because it’s the customer base, but invoice financing had a reputation of being lending of the last resort.
“So small businesses may believe that if their suppliers think they’re factoring, it means they must be in trouble. This is a misconception, of course, as although some businesses may need help through difficult times, the prime reason for using factoring or invoice discounting is to fund growth.”
Put simply, the fundamentals of factoring and discounting are the same, but the latter is a confidential arrangement and relies on the supplier to collect payment in the usual way.