How does it work?
Let’s say you run a catering company, and you’ve got a big job coming up soon. To finish the job, you need to buy all the ingredients, hire some extra equipment and employ a few members of staff. And you’ll only be paid for the job when it’s done.
You decide to use some of the money from your previous job but there’s a problem – the client hasn’t paid you yet. The invoice for that job has a payment term of 30 days. This is where invoice financing can help.
To get the funding you need, you approach a lender and secure invoice financing. The lender agrees to pay 75% of the invoice you’re owed from your previous job with an interest rate of 3%.
Here’s how that breaks down:
Invoice amount owed: £5,000
Advance amount (75%): £3,750
Fee (3%): £150
So the lender gives you an advance of £3,750, which is 75% of what you’re owed. When the customer pays the invoice in full, that money goes into a bank account which is controlled by the lender. From the money that goes in that account, you get to keep the remainder of what was owed (£1,250) minus the lending fees (£150).
What are the different types of invoice finance?
There are two main types of invoice finance, and they work in different ways.
Invoice factoring essentially means that you give control of collecting the money for your invoices to a lender instead of doing it yourself. Each time you raise a new invoice, the financier effectively buys the debt owed by the customer and advances you a percentage of the total invoice amount. The financier then collects the full amount from the customer themselves. When they get paid, they transfer the remaining sum owed to you, minus their interest and fees.
One of the main disadvantages with most factoring products is that your customers will know you’re using invoice finance, as the financier will collect the money from them directly. There are a few lenders who offer a confidential factoring services, so your customers won’t know you’re using the facility.
One of the biggest advantages of invoice factoring is that you’re basically outsourcing your ledger management to someone else. This could be a big help for small businesses who don’t have time to chase customers for payments.
This is the type that’s most similar to the example we used above, for the catering company. With invoice discounting, you still manage your ledger and you still collect payments yourself. In a way, invoice discounting is like a bank overdraft – you have access to short-term cash when you need it and you pay a fee for that access.
What’s the best option for my business?
Deciding what kind of finance is best for you depends on your business and your customers. Both factoring and discounting each come with their own advantages and disadvantages.
The best way to work out which option is right for you is probably to decide how much control you want. With factoring, you give up control of collecting debts – and with discounting, you retain control.