Invoice financing is an effective way for small- and mid-sized firms to fund growth or ease cash flow problems. In 2022, the market is booming, with healthy competition and plenty of funding.
However, the choices can seem overwhelming, with many types of invoice finance, each suited to a specific business need. And the landscape is changing fast. Fintechs, backed by private equity or hedge funds, are entering the market with new products and promises of better service, leading the traditional players to reposition their offerings.
This Buyer’s Guide to Invoice Finance aims to help businesses make the right decision. Note this article is for general information and does not constitute financial advice.
What is invoice finance?
Invoice finance is simple in concept. When a company issues an invoice, it gets paid almost immediately by a finance company. When the customer finally settles, the company will receive the balance, minus a fee.
Typically, a company will receive 70% to 90% of the invoice value 24 or 48 hours after invoicing, depending on the payments record of their industry.
Adam Stevens, credit insurance consultant at Allianz Trade UK & Ireland, said: "If a business has a turnover of £1m on 60-day payment terms, they're going to have more than £150,000 tied up in invoices they can't get their hands on. Invoice finance means companies can generate the cash to deploy where they most need it."
Invoice finance has a long history of helping growing businesses in the UK and Ireland, especially when banks have been reluctant to lend to businesses. Acknowledging its importance, the UK government changed the law in 2018 to make invoice financing easier. Invoice financing was brought into the Coronavirus Business Interruption Loan Scheme, the Recovery Loan Scheme, and Ireland’s COVID-19 Credit Guarantee Scheme.
An important thing to remember: this finance needs invoices on credit terms to function. Companies that don’t issue invoices, or issue invoices for immediate payment, cannot use this form of finance.
The key issues when buying invoice finance?
When looking at invoice finance, there is a crucial decision to make: factoring or invoice discounting?
Factoring is where the finance company not only advances cash against invoices, it does all the work chasing for payment.
Invoice discounting is where the company receiving the finance retains its accounts receivables department and chases invoices for payment as usual.
Here are some pros and cons:
A question of size: If your turnover is less than £100,000 or you have less than six months of trading, factoring may be your only option. You may be able to transition to invoice discounting after you grow.
Customer relationships: If you choose to factor, then the finance company, not your finance team, will be chasing your customers for payments. They may be less charming than your own staff. You also lose the ability to offer valued customers payment leeway to further your relationship.
Do you really want an accounts payable department? If you are a lightweight company with a tight focus, you may welcome the reduced admin that comes with factoring. You raise an invoice, send it to the factoring company, get the cash, then get on with the next project.
Adam Stevens commented: "Some businesses see this as positive because they don't need a full-time credit controller within their business. If you're an infant company, maybe you don't want to pay someone to do this."
What does it say about your firm? If you raise funds via factoring, it has to be disclosed to customers. Will they worry you're running low on funds? Adam comments: "A lot of people remember the 1990s when factoring was a dirty word because it was the lender of last resort. It's not anymore. It's an efficient way for businesses to generate cash."
Time factor: Factoring is quicker to set up. However, cancellation periods are usually longer.
Disputed invoices: These can be a headache no matter which form of invoice finance is chosen. Disputed invoices are generally taken out of the finance programme, you will in effect have to pay back the advance made, and you and the customer will have to sort out your dispute. Invoices financing works smoothest in industries where disputes are minimal or modest.
CHOCC and other developments
The market for invoice financing is changing fast as new players arrive and some traditional ones leave. New variants help ease some of the dilemmas above.
For instance, some factoring providers act almost as if they were your own finance team. The factoring relationship will be formally disclosed, but if your customer rings the number on your invoice, they will answer with your company's name.
One hybrid product is known as CHOCC (customer handles own credit control). You invoice customers and chase credit as usual, but the payments go into a bank account run by the firm providing invoice finance This can be useful for companies with many low value invoices, which can incur high handling charges in traditional factoring.
Some providers offer selective invoice finance, allowing you to discount invoices from only some of your customers, or even pick individual invoices to discount. This can be useful if you have a new, large customer on lengthy terms or only need occasional financing, for instance to stock up ahead of Christmas
New to the market is lending that is secured on a debtor portfolio. A lender will advance funds secured on your portfolio of invoices without going into details of individual invoices and whether they have been paid. This innovative, low-admin option is half-way between invoice finance and conventional lending.
How much does invoice finance cost?
Typically, a service fee is levied as a percentage of business turnover plus a discount margin, typically ranging from 0.5% to 4%, which is equivalent to the interest rate. There may be disbursement fees - in effect, fees for moving money around. And there are fees for setup, which can be complex and need careful scrutiny. For selective invoice finance, fees may be levied if the volume of invoices discounted falls below a certain threshold.
One additional issue to examine is what is the cancellation period if you find the policy isn't right or no longer needed? Fees for early termination vary widely.
Many tech-intensive players can make invoice finance offers very quickly, reading data from cloud accounting packages such as Xero or Sage. Adam says it’s vital, though, to look at the whole package and not just pick the first and fastest offer: “Make sure that all charges are thoroughly investigated and discussed from the outset.”
The market is diverging, he notes. Many new providers focus on automation and low discount margins (but watch out for other fees). Some of the established players in contrast emphasise service and the personal touch, giving every client a relationship manager who understands their business - very helpful if business is disrupted by a new Covid variant or supply chain problems.
It is worth asking if the lender is a member of UK Finance. Invoice finance providers who are members of this association must follow a dummy.
Some firms use a broker to help find the best deal, especially if they have unusual requirements. Check if the broker is a member of the National Association of Commercial Finance Brokers (NACFB), as it means they follow its dummy.
What if the customer doesn’t pay?
A vital question. Invoice discounting protects you from late payment, but it offers no protection against non-payment. If the customer goes out of business, it will be taken out of your facility balance.
Invoice finance providers will typically add bad debt protection for an additional fee. But it's possible to get trade credit insurance from a different provider—and there may be excellent reasons to do so.
Firstly, shopping around may yield a better price.
Secondly, you can personalise. Trade credit insurance from a specialist provider can be customised for sectors with specific needs, such as media, recruitment, contractors, or the travel industry. This can include options such as getting paid if a customer fails before you have issued an invoice but have incurred costs for work-in-progress. You can also broaden cover, for instance getting trade credit insurance for your whole customer base while only financing some of your invoices.
Additionally, a direct relationship with a trade credit insurance provider such as Allianz Trade comes with extra advantages, most notably the detailed flow of information, right down to the level of individual customers that can help proactively manage risk.
Adam comments: “We've saved businesses a lot of money by working directly with us.”
This ability to shop around makes buying invoice finance a little more complex. But buying invoice finance is an important step and needs careful consideration. Done right, it can transform a business, releasing cash to fund growth and reducing risk.