How to enhance cashflow with invoice financing
Updated 04 July 2022 • 8 min read
Steady, stable cashflow is vital for small business success. But even if your sales are excellent, cashflow might be anything but steady.
Differences in contracts and payment terms can mean invoices are paid at odd intervals that leave gaps in your revenue.
That’s where invoice financing comes in. This form of finance essentially provides an advance on outstanding invoices, which you can repay when the invoice is paid by your customer.
That makes it a convenient option for many but will it work for you? Read on to find out if business invoice financing is right for your small business.
What is invoice financing?
Invoice financing means borrowing money against the outstanding balance on an invoice as owed by your customers.
It’s a way for businesses to enable more consistent cashflow when customers have different payment terms or are late to pay. Instead of waiting for the customer to pay, the business borrows the invoice amount from a lender and repays it when the invoice is paid, usually along with some interest.
Invoice financing is sometimes called invoice discounting, accounts receivable financing or receivables financing. It’s similar to, but not quite the same as, invoice factoring (another form of invoice funding, but we’ll have more on that later).
How does invoice financing work?
Invoice financing is a fairly simple process. Let’s say you provide your world-class service to a client and then send them an invoice for payment. That invoice has a 30-day payment term.
For the next 30 days, while you wait for the client to pay the invoice, you’re effectively operating out of pocket. You haven’t received the money yet, so unless you have substantial working capital on hand, you may find it difficult to pay for operating expenses.
Alternatively, you can take out a small loan against the balance of that invoice — that’s invoice financing. You get the money upfront and repay the loan when the invoice is paid by your client. This can help smooth out the bumps that can come from having multiple invoices outstanding with different clients that all have different payment terms.
The exact terms of the financing agreement vary from lender to lender, but generally, the loan will be for around 80% of the invoice total. Your business will also need to pay service fees and/or interest to the lender, which is how they make their money.
Invoice financing vs. invoice factoring
Invoice financing and invoice factoring are two similar-sounding services with some subtle (but important) differences.
Invoice financing for small businesses, as mentioned above, is essentially the process of taking out a loan for a percentage of the amount of an outstanding invoice. Your business can then make use of that capital without needing to wait for sometimes-lengthy payment terms.
For example, let’s say your business has $80,000 in outstanding invoices, with payment terms ranging from 30 days to 120 days. In practical terms, that means that you may only have a vague idea of when exactly you can expect that money to hit your accounts. Even if you know your clients well and can narrow down exactly when they’ll pay their invoices, you still have to wait for the funds to become available.
Invoice financing aims to solve this cashflow problem by making the majority of these funds available immediately through loans. These loans tend to be for approximately 80% of the total of the invoices, with some variability based on the specific lender you go with.
The big advantage of invoice financing is that it enables your business to retain responsibility for collecting payments — in other words, the customer doesn’t know you’ve taken out the loan, and they still make their payments to you, rather than the lender.
Invoice factoring is similar to invoice financing from your business’s perspective — in fact, it’s usually considered a subtype of invoice financing. With factoring, a lender gives you the money upfront in one lump sum. But invoice factoring differs from invoice financing in a significant way.
The first is that invoice factoring involves selling your invoices to a third-party financier, rather than simply taking out a loan based on the amount. That means when it’s time to pay, your clients will be paying the financier, not your business.
For some, that’s not a big deal. But for many businesses, this might not be the most desirable approach — it may seem a bit off-putting or confusing to some customers, and while it takes responsibility for collecting the payments off your plate, it also means you have no control over the interactions between the financier and your customers.
To cover the costs and risks of taking on these debts, the financier or factoring company typically buys the invoices at a discounted rate. For example, if you sell $100,000 worth of invoices at a 4% discount, you’d likely receive $80,000 up front and the remainder, minus the discount, when the invoice is paid to the factoring company.
Advantages and disadvantages of invoice financing
Invoice financing is a relatively new financing option. It has clear advantages — quick access to money that you may need for operating expenses. But it also has equally clear disadvantages.
Let’s dive into the pros and cons, starting with the former.
Invoice financing advantages
Invoice financing provides a powerful non-debt option for businesses that need access to money quickly. Here are a few reasons you might consider it.
The number one advantage of invoice financing (and ultimately the primary reason you’d consider it) is improved cashflow. The ability to access funds that could be months out opens up huge possibilities for businesses of all sizes and makes it much easier to cover predictable expenses.
Qualify quickly and easily
Invoice financing tends to have more lenient qualification requirements than some other types of financing. Provided your business has a clean financial track record, you should be able to get approved.
Extend payment terms to customers
The improved cashflow and easy qualification for invoice financing can enable your business to extend more flexible payment terms to its customers. This is especially important for newer businesses that need to meet industry standards but may not have the liquid capital to cover operating expenses without faster payment.
Avoid fixed-term repayments
One of the largest problems with most financing options is that you need to make payments on a fixed schedule, regardless of your cashflow situation. Invoice financing is typically paid off when the invoice is paid, so this becomes a non-issue in most cases.
Scale funding with your business
Invoice financing is more scalable than many other types of loans since the amount borrowed scales directly with your outstanding invoices — in other words, as revenue goes up, you borrow more.
Reduce the risk of late payments or bad debt
Invoice factoring, in particular, can drastically reduce the risk of late payments and non-payment. Since the lender assumes responsibility for the invoice with factoring, your company no longer needs to worry about it, which can be very freeing.
Invoice financing disadvantages
As with any type of financing, there are downsides to invoice financing. Consider the following before making a decision.
It may cost more than other financing methods
Invoice financing has a tendency to be more expensive than other types of loans. Although the situation is gradually improving due to increased competition, you should carefully compare rates to make sure invoice financing or factoring makes sense for your business.
You don’t collect 100% of the invoice value. Similarly, you won’t see the full value of your invoices with most financing options. The fees and costs are generally taken directly off the top of the invoice amount.
You may encounter invoice limitations
Invoice financing may actually restrict the companies you can do business with. Since the loan repayment is entirely based on the invoice being paid, most invoice finance companies will only provide an advance on invoices to trustworthy companies. This typically means that invoices to larger, more established businesses are more likely to be approved for financing.
Financing is limited to the invoice balance
Traditional loans are quite flexible in terms of how much you can borrow. Invoice financing, on the other hand, is limited to the amount of the invoices in question. If you need larger amounts of capital, you’ll likely need to look elsewhere.
It may impact your customer relationships
Invoice factoring, where the financier takes over responsibility for the invoice, may leave a bad taste in the mouth of some businesses. Not every company will want to deal with a third party. Fortunately, there’s a workaround for this: invoice discounting, which leaves the handling of the invoice in your company’s hands.
Potential liability for unpaid invoices
If your customers are late to pay their invoices, you may be held responsible by the invoice financing provider. If you’re dealing with new clients and you’re unsure how reliable they are in this regard, you may want to consider other options.
Is invoice financing right for your business?
Invoice financing can be a simple way to secure funds for your business when you need them. While it may not suit all businesses, the advantages for those it does are compelling: it’s easy to qualify and scale your funding without overextending your repayment ability.
If you’re interested in small business invoice financing, MYOB can help. We’ve partnered with Butn to provide eligible customers with quick and convenient invoice financing options.
Getting started with tax invoices
How to handle clients not paying invoices
How to create an invoice in 9 steps