SME guide: What is invoice finance and how does it work?

What is invoice finance?

As an SME, invoice finance gives you fast access to money you’re owed by your customers. In other words, you borrow money against invoices you’ve already submitted to customers.

This makes invoice finance very different from a normal loan, which is typically based on the hope that you’ll have more money in future. With invoice finance, you already have earned the money – you just haven’t been paid. 

How does invoice finance work?

Here’s an example of invoice finance in action:

• You’ve supplied goods or services to a customer worth £10,000 and you send them an invoice as normal. You’re now owed £10,000.
• You submit the invoice to your invoice finance provider – this can be a bank, a specialist lender or an online platform.
• The lender immediately advances you a large percentage of the invoice, usually 70% to 90% of its value.
• Your customer pays the invoice, either to you or directly to your lender, depending on the arrangement.
• You repay your lender the amount they lent you plus their fees, or your lender pays you the remaining balance of the customer’s invoice, minus their fees. This depends on the type of invoice finance arrangement.

Once an invoice finance funding arrangement is in place with a lender, it’s quick to receive money for customers’ invoices: usually within 48 hours and, for more modern lenders, as soon as you issue an invoice. 

Who uses invoice finance?

Invoice finance is particularly valuable for businesses who invoice all or a large proportion of their fees after they’ve done work, or sell to other businesses on lines of credit. Think of a plumber or electrician who buys materials and serves customers, but only invoices once their work is complete. Most smaller trade businesses do the same – as do many larger businesses.

Other sectors that are likely to benefit from invoice finance include:

• Construction and engineering firms: costs are incurred on labour, materials and equipment, but the business can usually only invoice once a milestone is met. 
• Manufacturing businesses: raw materials and production incur costs upfront, and often businesses need to offer extended payment terms to compete; payment can be many months after costs are incurred.
• Haulage and logistics companies: fuel and wages have to paid for weeks or months in advance of customer payments.   
• Recruitment firms: temporary staff need to be paid weekly or monthly, but payments from clients generally take much longer to be received.
• Wholesale providers: goods are bought in bulk from suppliers and then often sold on credit, creating major gaps before payment is received.

For businesses like these, a funding option that can bridge the gap between costs and payments can make the difference between thriving and going out of business. 

Why is invoice finance so valuable to growing businesses?

Growing businesses find invoice finance particularly beneficial, because they often have plenty of sales but far less cash.

Imagine you’re a small manufacturer with a team of 25 people. Your products are getting noticed, you’ve starting to sell significant amounts, and over a short period you double your sales. This sounds like a great situation, but it can put major strains on your business. You must now source more raw materials, lease more equipment and hire more staff – all of which costs money.

Most businesses, especially recently established businesses, simply don’t have cash lying around to cover these costs. Although you’re owed lots of money, new orders are coming in and your business is doing well, you could still face bankruptcy if you mishandle the situation.

Successful businesses will frequently struggle with cashflow in this way. Indeed, it’s often success that puts the most pressure on company finances.

Invoice finance is an excellent tool to bridge the gap. Instead of borrowing against an asset – which is then put at risk – or taking out a risky unsecured loan, you borrow against money you’ve already earned. Even if sales dip in future, you can pay back what you’ve borrowed as your invoices are settled one by one.

What different types of invoice finance are available?

Banks, lenders and online platforms offer different types of invoice finance – each with different benefits. In each case, the basic concept of receiving an advance on invoices issued remains the same.

Factoring

In a factoring arrangement, the lender ‘buys’ the invoices and takes responsibility for collecting payments from customers, which means customers know about the arrangement. This contrasts with invoice discounting, where the business retains responsibility for collecting payments. (See below.)

Pros: 

• Quickly receive up to 90% of the value of your invoices. 
• Easier to secure for smaller and newer businesses, because the lender has full visibility of your sales ledger and can manage their risk.
• Lender handles credit control, saving SMEs time and effort.

Cons: 

• Typically more expensive than invoice discounting, because the lender does credit control on the borrower’s behalf.
• Potential damage to relationships with customers, especially if the lender pursues payments aggressively. Customers may lose confidence if they know you are using a lender. 
• In the past, factoring was seen as a very time-intensive form of borrowing for SMEs. This is no longer the case. (See ‘eSync’ below.)

Who might use it:

Smaller businesses are most likely to use factoring, as it’s easier to get than other forms of invoice finance and takes away the hassle and stress of chasing payments. 

Bulk invoice discounting

In a bulk invoice discounting arrangement, you submit a ‘bulk’ sales ledger figure to a lender each month, without details of individual customers and invoices. The lender lends a set percentage of the total amount. You remain responsible for chasing payment, and your customers typically don’t know about the arrangement.

Pros: 

• Gain a regular flow of funding. 
• Your customers don’t know about the finance facility. 
• Simple for you to manage.
• Lower fees than factoring.

Cons: 

• Harder for smaller or less established businesses to obtain, because the risk is higher for lenders.
• No support with payment collections.

Who might use it:

Larger, more established businesses that want reliable, ongoing funding to cover cashflow gaps.

Selective (or ‘single’) invoice finance 

In a selective invoice finance arrangement, you select specific invoices to borrow against. The customer typically won’t know about the arrangement with your lender.

Pros: 

• Get funding for a large, important invoice without signing up for a full invoice finance facility.  
• A more flexible, one-off solution that gives you more control. 
• Useful when you have a particularly slow-paying client.  
• Your customers don’t know about it.

Cons: 

• A stop-start form of funding.
• More admin work than bulk ID, if used frequently.

Who might use it:

Businesses that only need funding now and then for particularly large invoices or to manage slow-paying customers.

Shadow invoice discounting

In a shadow invoice discounting arrangement, the lender maintains a copy of your list of open and closed invoices – a ‘shadow ledger’. This means the lender can see who your customers are and the amounts they owe. This is a confidential arrangement; your customers don’t know the lender is involved.

Pros: 

• Quickly receive up to 90% of the value of your invoices. 
• Potentially lower fees because the lender has a greater understanding of risk. 
• Your customers don’t know about the arrangement.

Cons: 

• Borrowers must upload invoice data to their lender on a regular basis. Without electronic data sharing, this can be time-consuming.
• No support with payment collections.

Who might use it:

Businesses of all sizes that are happy to share more information about their customers in exchange for more cost-effective funding.

eSync 

eSync is a streamlined, modern form of invoice finance in which you connect your accounting system to your lender’s systems. This gives the lender full visibility of information including your complete list of invoices, any late payments, who your customers are and how long they take to pay, any credit notes, and so on, allowing them to work more efficiently and manage risk better. For you, this translates to faster access to funding and – potentially – lower fees. Your customers may or may not know about the funding arrangement.

Pros: 

• Gain funding more quickly 
• Much less admin work. 
• Potentially lower fees and a higher percentage funded per invoice (ie. ‘advance rate’).

Cons: 

• Lenders have full visibility of customers and payments – although if there’s nothing to hide then this is not a negative.

Who might use it:

Businesses of all sizes that are happy to share full information about their invoices and customers in exchange for more efficient and cost-effective funding. 

Read more about eSync here.

The impact invoice finance can have – an example

A wholesaler invoices a chain of coffee shops £500,000 a month, on 60-day payment terms.

Without invoice finance:

• Month 1:  Invoice sent. £0 received.
• Month 2:  £0 received.
• Month 3:  Customer finally settles invoice from Month 1. £500,000 received.

With invoice finance (85% advance):

• Month 1:  Invoice sent. £425,000 received immediately, from lender.
• Month 3:  Customer settles invoice from Month 1. Lender pays remaining £75,000, less fees.

Result: instead of waiting two months for its money, the business receives most of it within a day or two. Without invoice finance, that two-month gap is a constant drag on the business.

Summary: what are the key advantages of invoice finance?

For SMEs, invoice finance can be a critical tool for driving business growth. Key advantages of invoice finance products include:

• Smoother cash flow.
• Support for rapid growth.
• Finance facility grows automatically, as sales increase.
• Facility is repaid automatically as invoices are paid – no saving up to pay back a loan. 
• Reduced reliance on overdrafts.

Glossary of key invoice finance terms

Accounts receivable ledger
AKA sales ledger
A full list of payments and amounts owed by customers for goods and services, including all invoices issued, credit notes, payments received and balances due.

Advance rate
The percentage of an invoice that a finance company will advance up front – usually up to 95%.

Aged debt
Money owed to a business.

Availability 
Amount of funding the client can access.

Bad Debt Protection (BDP)
Optional insurance borrowers can take out to cover them against unpaid invoices if a customer goes bankrupt.

Concentration 
A concentration in a sales ledger is the proportion of a business’ outstanding invoices that are issued to one customer. A ‘concentrated debtor’ is one that represents a significant proportion of the ledger.    

Credit control 
AKA receivables management, accounts receivable management
Processes designed to ensure customers pay on time, such as reminders and statements.

Dilution
A reduction in the value of an invoice. For example, if a credit note is raised, goods are returned or there is a dispute over pricing. A dilution can be a warning sign of increased risk for a lender providing an invoice finance facility.

Disclosed / Undisclosed
In a disclosed arrangement, the borrower’s customers know about the invoice finance facility; in an undisclosed arrangement the funding is confidential to the borrower.

DSO
‘Days Sales Outstanding’ is a measure of how long it takes for a company to collect payment after making a sale.

Non-recourse
Funding arrangement where the lender takes on the risk of customer non-payment, including bad debt and insolvency.

Open Accounting
Technology that connects businesses’ accounting systems with financial institutions, for sharing financial data.

Utilisation
The percentage of available funding that a borrower uses, from their lender. 

About Dancerace
Banks and lenders worldwide depend on Dancerace software to deliver intuitive, transparent invoice finance products. To learn more about invoice finance, visit our blog.