FundOnion's Guide to Invoice Finance

Want to harness the power of your invoices to really get your cashflow moving? Find out how right here.

1) Introduction

Invoice finance can be a big help to small businesses. It can assist in making your incoming payments more predictable and getting customers to pay more quickly.

In the UK, invoice finance has exploded in recent years and has become more and more popular. In fact, a recent report by IGF pointed out that 27% of SMEs are now using invoice finance.

Even though invoice finance is being used by many more businesses these days, it’s still a fairly misunderstood financial product. So we’re going to tell you everything you need to know in our Rough Guide to Invoice Finance.

It’s all going to be in plain and simple English with no financial jargon or buzzwords. That makes a change for finance stuff doesn’t it?

What is invoice finance?

It’s a kind of catch-all name for any kind of financing service which uses a company’s invoices as security to give them cash in advance. It’s also known as accounts receivables financing or receivables financing.

There are two main types of invoice finance: factoring and discounting:

  • If the lender collects payments from your customers that’s factoring
  • If you handle your own credit control and chasing of invoice payments that’s discounting

Within these two categories, the products vary depending on whether or not they are:

  • Whole ledger – the invoice finance product covers all of the company’s invoices
  • Or selective – the invoice finance product only covers specific invoices from time to time

How does it work?

Basically, you sell your unpaid invoices to a lender, who then gives you a cash advance of a percentage of that invoice - usually between 80% and 90% of the invoice value.
When the invoice is eventually paid by your customer, the lender gets back its advance plus any other fees.

Any remaining amounts, for instance the other 10% or 20% of the invoice are also paid back to you.

It’s not the simplest financial product out there but it can be very effective, especially if you have good sales but problems with cashflow.

Here’s how it works in practice:

Understanding Invoice Finance_Infographic

2) Factoring vs. discounting

As we said, there are two types of invoice finance: factoring and discounting.

The primary difference between these two comes down to who collects the payments from your customers. In slightly more detail:

  • Factoring - the lender contacts your customers, tells them about the invoice factoring and collects the payments straight from them
  • Discounting – you are responsible for collecting the payments and your customers don’t know about the invoice discounting facility

What are the fees?

  • Total interest paid for the 9 months = £11,250
  • Non-utilisation payable on £50,000 for 9 months = £225
  • Non-utilisation payable on £100,000 for 3 months = £150

That’s the main difference between the two. There are also differences in admin between the two. For instance, with invoice discounting you control your sales ledger and you choose the invoices you want to receive an advance against.

Generally, full invoice factoring means that the lender takes over the admin of all of your invoices.

What’s more, invoice discounting gives the lender much more risk so it’s usually only available to companies with £100,000+ revenue, a healthy balance sheet and reliable customers.

Invoice factoring on the other hand, is more suited to smaller businesses that need to unlock cash from their outstanding invoices.

3) Invoice Financing Companies Fees & costs

Fees are where invoice finance products get a bit tricky! That’s why you should always make sure you understand all of the relevant charges before entering into any agreement.

Invoice finance products usually have a number of fees, so let’s have a look at these – what they are, what they mean and how this all adds up:

Invoice Finance Fees_Infographic

Contract length and termination

This brings us to our second gentle warning: once you start using invoice finance it can be tempting to continue using it.

If you start factoring large amounts of your cashflow on a regular basis, then you’ll start to need invoice finance. That’s because you’ll have a cashflow gap each month as you send out your invoices and also pay off your lender with incoming funds.

We’re not saying that invoice finance isn’t useful, it is. But be very aware of what you’re getting into and for how long. On this point, an invoice financing company contract usually last for 12 months – that’s 9 months contract length with a notice period of around 3 months.

If you’re not keen on committing yourself like this, then selective invoice finance lenders might be a better option for you.

Selective invoice factoring

Selective invoice finance products usually have much simpler fees than what we outlined above. They often have a flexible contract which means that once the lender has approved you, you can factor or discount selected invoices as and when you need to.

But nothing in life is free obviously. So you’ll pay slightly higher fees for this kind of product as the lender will charge you more for the flexibility.

4) Will it work for you?

Invoice finance can be useful if your company has problems with cashflow and you need to keep paying employees and suppliers.
It can also helpful in limiting the amount of debt you build up. That’s because the cash advances you receive for your invoices will be in proportion to your revenue. So you won’t be saddling your business with more debt than you can pay off.

In short, invoice finance is like a service that helps relieve your cashflow problems -and that service is paid for through a percentage of your profit margins.

It can certainly be very useful if your business:
  • Has seasonal sales
  • Needs a short-term cashflow boost
  • Doesn’t qualify for other financial services like business loans or revolving credit – or can only get them very expensively

There are other non-traditional uses for this type of finance, such as using it to acquire another business. In the past there was a trend towards buying a company by invoice financing the company’s outstanding invoices.

This is still possible in theory, but you should talk to a broker or financial adviser before going down this route.

5) Applying

So let’s look at this from the lender’s point of view.

The lenders’ biggest risk is that your customers won’t pay their invoices. So they’ll want to check out your business and understand it.

What’s more, as your advances are based on your invoices they are not that concerned about your forecasted revenues. But they will want to confirm that your customers’ invoices are real, as unscrupulous business owners have forged invoices in the past!

6) Concentration Limits

In addition, they will often insist on a concentration limit in the arrangement. This simply means that a percentage of your approved funding limit can be used for an invoice to a single customer.

However, this does mean that if most of your invoices go to a small number of customers, it can be harder for you to secure invoice financing.

Here’s another gentle warning and this is something to check before even thinking about speaking to a lender.

If your company sells stock or other inventory, and your customer contracts have a sale or return clause in them, this can cause a problem with some lenders. That’s because they can’t confirm an invoice has its value until after the customer has paid it.

When applying for any kind of invoice finance, you’ll need to give the lender the following information:

  • Your latest statutory accounts for the business
  • Management information including an up-to-date balance sheet and profit and loss statement
  • Lists of aged debtors and aged creditors
  • Examples of key contracts with your customers
  • An overall understanding of your business and your billing cycle - from issuing the invoice to collection of payment
  • An ALIE Form (stands for "assets, liabilities, income, expenditure")

When deciding how much negotiating power you might have for invoice finance, you need to look at:

  • How big your trade debtors’ book is – what’s the total of all your unpaid invoices at that point in time
  • How much the outstanding amount of all your unpaid invoices is spread across your customers – the concentration limit mentioned above
  • How much you’re owed from time to time
  • How frequently your customers pay and when it happens

In addition, lenders will probably ask for legal paperwork and other protection such as:

  • A debenture on your business – this is a loan agreement in writing between you and the lender that is registered at Companies House. It gives the lender security over your assets
  • A personal guarantee from your directors
  • Or a warranty if no personal guarantee is required
  • A signed facility agreement

Invoice finance has become an extremely popular method of business finance in recent years. This is especially true among the 28% of IT and telecoms companies across the UK who now consider invoice finance a top funding source.

According to data from UK Finance, funding for small businesses via invoice finance and other forms of asset-based lending was around £22.7 billion at the end of 2018 – that’s up 2.5% on 2017.

What’s more, the number of companies in the UK who use invoice finance and other asset-based lending is around 40,000. So it’s definitely popular with small businesses of all shapes and sizes.