Invoice finance is promoted as a way of improving cash flow and working capital for businesses. In this article we look at how invoice finance works and discuss the pros and cons of this solution to cash flow issues.
There are two forms of invoice finance, Invoice Factoring and Invoice Discounting.
Invoice factoring provides a prepayment against your sales ledger. You are effectively selling your unpaid invoices on to a third party, the factoring company (or factor). The ownership of the invoice passes to the factoring company and with it the responsibility to collect the money from your customer, who will be requested to pay directly to the factoring company.
To qualify your business will need to have an annual turnover of at least £100,000 – although some factoring companies will consider working with smaller businesses. The agreed advanced level can be up to 90% of the value of approved invoices with the balance being paid once the invoice has been settled in full.
There are two types of factoring – recourse and non-recourse factoring.
In recourse factoring the factor does not take on the risk of bad debts and non-payment by your customers. The factoring company will reclaim the money they advanced to you if the customer does not pay within a certain time period. Your contract will state how many days after the due date for payment you must refund the advance.
In non-recourse factoring the factor takes on the risk of the bad debt (although if an invoice is disputed the factor will require you to pay the advance back). As a result it is more expensive than recourse factoring. It accepts specific risks around the customer inability to pay but it will not insure against debts that have a genuine dispute. The factor takes over all rights to pursue the customer for payment including the right for legal action
The factor will charge you a service or factoring fee and interest as well. Typical costs for the service fee / agreed factoring fee range from 0.5 – 3% of the total value of the factored invoices Interest is usually charged at 3% above the Bank of England base rate and calculated against the balance of funds drawn. Interest is worked out on a daily basis and charged out monthly – often being taken against your available funds limit.
Invoice discounting works in a similar way to invoice factoring with the difference being that you remain responsible for the collection of the debts – it is therefore a more discreet way of borrowing money as your customers need not know that you have taken financing on your invoices.
The invoice discounting company (or discounter) will charge a monthly fee for the service and interest on the amount borrowed against sales invoices.
Invoice discounting tends to only be available to businesses that sell products or services on credit to other businesses and have an annual turnover of at least £500,000. Again, like factoring the agreed advance level can be up to 90% of approved invoices with the balance being paid once your client has paid the invoice.
The discounter may not lend against invoices to all your customers for example if they have a poor credit rating, special extended credit terms or small value invoices.
Costs are less than for invoice factoring as you are still responsible for collections. Typical charges are 0.2 – 0.5% of your turnover, plus interest costs of around 3% above base rate.
Invoice financing is an expensive form of finance and can be difficult to escape once your business has become reliant on releasing cash from invoices on the day they are invoiced. A well-managed credit control function is an alternative approach. Make sure your customers pay you on time, every time and there will be more cash in the bank.
Now you can outsource your credit control, making a strong credit control function an option for businesses of all sizes.
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