Invoice Finance

A guide to Invoice Financing

Any business, no matter what size it is, needs to maintain a high level of financial stability if it’s to remain profitable from year to year. No matter what industry a business operates in, the ability to change and adapt to new circumstances is vital to ensuring that a business can meet changing pressures from an evolving market, and it’s necessary to have a secure form of financing in place to enable this resilience. The key measure of a business’s flexibility is its access to capital, and while many businesses might be able to use other forms of finance to provide cash for one-off expenses, maintaining a steady cash flow is a demand that’s best satisfied with invoice financing. Invoice finance can provide businesses of all sizes with the capital they need to stay flexible and financially adaptable, and while not all businesses will be familiar with how invoice financing works it can be highly beneficial to gain a thorough understanding of this exceptionally useful form of lending.

Invoice financing is a highly specialised type of commercial lending that’s used to maintain a business’s cash flow. As with all forms of lending, any business making use of invoice finance must understand the impact this will have on their overall profitability - invoice finance isn’t free, and while it provides many useful benefits business owners should carefully consider whether it suits their business needs before committing to it. As with any finance product, a financial advisor should be consulted in order to assess whether invoice finance is an appropriate solution for the business’s situation.

Capital and cashflow sources

Large businesses with a turnover in the millions of pounds can often source large amounts of capital at short notice. The sheer size of these corporations and the amount of assets they have on hand generally enables them to acquire finances fairly easily, and they may have short-term finance options such as revolving trading facilities in place to help them meet unexpected costs. However, for businesses without so many assets there are fewer options, and a lack of access to capital can be tough to overcome. For instance, while a major corporation might be able to easily transfer capital from one division to another to meet expansion costs, a smaller business might have no such option available to them. In situations like this, the smaller business may be forced to take out asset finance whether it’s suitable or not, which is far from ideal.

It’s therefore important for businesses to have access to a steady and reliable source of cashflow, in order to avoid a shortfall in capital. When money can be generated at a predictable rate it can be relied upon to cover planned expenses such as employee salaries, maintenance and purchase orders. Invoice finance is a method for evening out a business’s cashflow by paying invoices at a reliable rate - always on time, and always in full.

The need for invoice financing in business

So, let’s examine how invoice financing actually works. First of all, we need to understand why invoice finance has been developed in the first place, and the problem for which it provides a solution. As a company fulfils orders, it creates invoices for each client - when an order is completed, the invoice is generated and sent to the customer. The customer then has a term of 30 days in which to pay; this is to allow businesses some flexibility over when and how they pay, and while it’s important to enable this flexibility it also means that invoices can go unpaid for 30 days at no penalty to the invoicee. This poses a problem to the supplier, because although they’ve paid out the manufacturing, storage and delivery costs to fulfil the order they can’t rely on receiving any money for another month - they’re running at a deficit, and they still have to cover overhead costs in the meantime.

Because businesses can’t rely on the income they generate from filling orders, they must constantly operate with a surplus of cash in their accounts to meet costs. For instance, if a supplier has monthly operating expenses of £20,000, they must maintain this amount of capital as a “cushion” to guard against slow-paying customers, guaranteeing that even if their invoices aren’t paid they can still afford to pay employees, mortgages, finance plans and purchase orders. This is far from ideal, because there are much better things the business could be doing with this £20,000 - subsidising staff training, for instance, or investing in new, better equipment and machinery. Therefore, if a business can eliminate the uncertainty surrounding 30-day invoice payment periods, they can re-invest more money into becoming a more profitable company.

How does invoice finance work?

Invoice financing is designed to meet this need, and to provide businesses with a stable, reliable source of income from their invoices. In essence, invoice finance providers act as a third party to the supplier and their customers, and fulfil the role of an intermediary; the invoice finance provider “buys” invoices from the supplier at a discounted rate as soon as they’re issued, and once they’re paid they return the full balance of the invoice - they make their money either through a standing fee or a percentage of the invoice’s value.

Let’s examine how a typical invoice finance deal might work. First of all, we have our supplier, who fills an order for £100,000 worth of work and issues an invoice to their client. Upon issuing the invoice, they notify the invoice finance provider of the value of their invoice, and provide evidence that the work has been completed and accepted by their client - this verification process is important to ensure that the invoice is viable and will be repaid without issue. Once verification is complete, the invoice financier will then transfer a percentage of the invoice’s value to the supplier. The amount that they transfer varies from deal to deal, and is affected by the supplier’s overall creditworthiness, size and the value of their invoices. In this instance, our supplier will receive 80% of the invoice’s value, so they’re paid £80,000 immediately upon issuing the invoice. They can then immediately put this to use however they see fit; they may use it to fill another order, to purchase more equipment or to hire more staff.

From the customer’s point of view, nothing has changed; they still pay their invoice as usual within the 30-day time limit, in full. So our business’s client makes use of their 30 day window to generate the cash to pay the invoice, and pays in the final week of the invoice date. They send their £100,000 across to the supplier, and the invoice is fully settled. The final step is for the supplier to repay the £80,000 they were supplied by the invoice finance provider upon issuing the invoice, along with whatever recompense their contract stipulates. Once the invoice has been fully paid, the supplier has received the full £100,000, with 80% of this coming “upfront” as soon as the invoice was issued. Their invoice finance provider has their £80,000 back, plus a profit on top, and the business’s client has received the services they purchased and has still been able to make use of the 30-day invoice payment period.

There are many benefits to a system like this, chief amongst which is the enhanced cashflow available to the supplier. While they may not receive the total value of the invoice initially, the ability to obtain such a large percentage of its value without waiting for the customer to pay up is a huge benefit. As discussed previously, businesses which are reliant on their clients to pay invoices on time have to put up a capital “cushion” in case of non-payment, which can have a substantial negative impact on their operations. When cash can be generated shortly after issuing an invoice a business can easily control their cash flow, and is no longer required to hold significant levels of capital on hand to ensure they can meet their financial obligations.

The costs of invoice finance

Invoice finance is about as close to a win-win as it’s possible to get; every party in the transaction gets what they want, but there’s still a price tag attached. The precise nature of the costs associated with invoice finance can vary significantly from one provider to the next, but there are two main methods which are used by invoice financiers to generate income from the services they provide. The profits of an invoice finance provider can either be created from a standing monthly fee for their services, or can be determined as a percentage of the invoices they process, and some financiers will combine these two methods.

A major determining factor in the costs of an invoice discounting program is the size of the invoices which are being processed. Obviously, a large business which is issuing high-value invoices will not want to pay a large percentage of these invoices as a fee to their invoice finance provider, and may wish to opt for a subscription-based service fee instead. However, invoice financing is only appropriate for businesses up to a certain size; if many invoices of a high value are being issued it may be tricky for an invoice financier to provide sufficient funding, which means lenders that have the necessary capital to accommodate large businesses may well charge a premium for their services.

This is why invoice financing is such an ideal solution for businesses that are a little further down the corporate ladder, such as SMEs. The costs of invoice finance can often be easier to accommodate in a smaller business with lower invoice values, and the benefits invoice finance provides often make a big impact for these smaller companies.

Who needs invoice finance?

Invoice finance is an appropriate financial solution for businesses in any sector, and the only determining factor is the size of the business itself. Generally invoice finance is appropriate for SMEs rather than large corporations, and it provides the most benefit to companies within this sector of the market. As outlined previously, a large corporation doesn’t really need the services which invoice financing provides; once a business reaches a certain (very large) size, it doesn’t need to rely on the capital generated from individual invoices, and can easily leverage assets to provide capital if it proves necessary. Businesses which survive from invoice to invoice, though, stand to benefit significantly from invoice financing, not simply because it can help to maintain cashflow when clients are slow to pay, but because it can also be used to outmaneuver and outperform the competition. A business which makes use of invoice financing can reliably fill orders and even bid for larger ones, safe in the knowledge that its invoices will be paid reliably.

Types of invoice finance

Just as with every other form of commercial finance, there are as many different types of invoice finance as there are invoice finance lenders. Each lender caters to a different type of client and will provide a different range of services - we’ve listed some of the main variations on the basic invoice financing scheme outlined above.

Invoice Finance & Collection:

With “standard” invoice financing the lender has no involvement with any party other than the supplier they’re lending to. However, in some cases a business will want to outsource the entire invoice payment process to a third party, and many invoice finance lenders also function as collection agencies. They can act quickly to ensure that invoices are paid on time, and will be able to chase up clients who are late to pay; this can be highly valuable for smaller businesses who don’t have a dedicated accounting department to fulfil this function on their own. If an invoice finance lender takes over this aspect of the invoice process then it becomes much more visible to the business’s clients, as they’ll no longer be dealing directly with their supplier when it comes to paying their invoices; instead, they’ll be liaising with an invoice financier. This isn’t necessarily a problem, but it’s something to be aware of when pursuing an invoice finance and collection package.

All In One Invoice Solutions:

Some invoice finance providers go one step further than collecting invoices on behalf of their clients, and will actually generate the invoices as well. These companies provide an all-inclusive invoice resolution service that covers everything from invoice generation to payment, and takes the entire business of invoicing out of the hands of the supplier. This can be exceptionally valuable to businesses with a small accounting department, as creating and managing invoices is a major function of their staff; by outsourcing this work, they can combine their invoice finance solution with the accounting work and minimise costs. While it’s generally more expensive to hire an invoice finance provider that will cover the entire invoice process, it can be more profitable to do so. For instance, if a business is paying out £22,000 per year to a junior accountant to handle their invoicing services, but an invoice finance firm is able to cover the whole process of invoice handling from issuing to collection for the same price, the business can get more for their money by rolling all their services into one.

Using Invoice Finance

There are a whole host of benefits to using invoice finance as part of a business’s overall financial strategy, and a well-balanced invoice finance plan should be part of any business’s tool kit. It’s important to understand the role that invoice finance can play in a business that’s seeking to grow and expand, and how this can enable other forms of finance to be used more effectively. Crucially, invoice finance can alleviate the pressure placed on a business’s cash flow to keep up with daily expenses, which liberates more capital for use in investment projects. Because there’s more capital available from invoices, businesses can be more flexible with other types of finance, too; they may be able to take on asset finance loans which would otherwise be unaffordable, and can use these asset-backed loans to secure large investments which would otherwise be beyond reach - new premises, property, heavy equipment and advanced training. This can make a business much more profitable in the long run, simply because it’s able to acquire a greater depth of overall funding.

While this article has discussed the many positive benefits of invoice finance, it’s important to remember that it’s not necessarily the correct answer to every single situation. There are many cases where invoice finance can provide highly beneficial to a business, but this doesn’t mean that it’s a no-brainer; it’s important that business owners understand when to use invoice financing positively, which requires a firm understanding of exactly how it works and what purpose it fulfils. This article has highlighted the areas in which invoice finance is exceptionally useful, and shows that while it may not be suitable for every business it should still be part of every business owner’s toolkit.

Further Reading

Official resources about UK regulatory bodies:

Other Unofficial Short Term Finance Guides

Covering areas of UK financial regulation and aspects of Bridging Finance.

Bridging guide by Bridging Directory