Invoice financing: What is it & is it right for your business?

What is invoice financing?

Invoice financing is a way for businesses to access funds that are tied up in unpaid invoices. When you send invoices to customers, you won’t see those funds right away; there’s a lag between when you send invoices and when you receive cash.

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Invoice financing lets you borrow against those incoming payments. Having access to those funds sooner makes it easier to pay for day-to-day necessities like rent, payroll, materials, utilities, and distribution.

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Invoice financing, also known as accounts receivable financing or receivables financing, isn’t the most common way to finance business operations, but companies with a lot of cash held up in unpaid invoices may benefit from it. Small businesses, startups, and business owners who struggle to get good rates on short-term financing may also be drawn to invoice financing.

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Invoice factoring is a similar way to get cash before receivables are paid, but it’s slightly different. Invoice factoring is when a company sells its accounts receivable (AR) to a third-party factoring company, who then works to collect payment from customers.

How does invoice financing work?

Invoice financing involves three parties:

1. The business (the party that issues the invoice)
2. The customer (the party that pays the invoice)
3. The financial services company (the party that provides the financing)

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Before a business can get financing, it must establish a relationship with a financial services company. The financing company typically requires the business to go through an application process, reviews the creditworthiness of the business’s customers, and asks for proof of earnings and asset balances. Based on the findings, the financing company draw up terms and conditions for future loans. Only once the relationship is established can actual financing begin.

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Here’s how invoice financing works, step by step:

1. The business sends an invoice: The business provides a product or service to their customer and sends an invoice
2. The business requests a short-term loan: The business sends a copy of their invoice to the financial services company, requesting a loan
3. The financial services company sends cash: The financing company issues a short-term loan to the business. The amount of cash it sends is a percentage of the outstanding invoice, which could be as high as 100% but is more commonly between 50–80%.
4. The customer pays the invoice: The customer pays the invoice as they normally would
5. The business pays off their loan: The business pays off the amount it borrowed, plus fees and interest

An example of the invoice financing process

A manufacturer delivers $50,000 worth of goods to their customer and issues an invoice with net-60 terms. To help pay for immediate expenses, they decide to finance that invoice.

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Their financing company agrees to front 70% of the invoice. They charge an annual percentage rate (APR) of 12%, compounded monthly, plus a flat fee of 2% of the invoice value. Within 48 hours, the financing company uses ACH credit to deposit $35,000 into the manufacturer’s bank account.

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Exactly 60 days later, the customer pays their $50,000 balance. That same day, the manufacturer repays their loan to the financial services company. The amount they pay should be $36,704, which consists of:

• The $35,000 principal
• 2% of the invoice value (2% of $50,000 is $1,000)
• Two months of interest (12% APR for two months, compounded monthly, is $704

Advantages and disadvantages of invoice financing

Invoice financing helps businesses get cash fast—typically within one or two business days. But quick access to cash is only one of the benefits. A few other benefits of invoice financing are:

• Requires no collateral: Unlike many traditional bank loans, invoice financing doesn’t require collateral other than the invoice itself
• No change to the payment process: In invoice financing, the business doesn’t sell rights to its receivables; it simply borrows against them. This means customers will pay bills directly to the business like they always have, ensuring no disruptions in the payment process or billing cycle.
• More flexibility: In most cases, the business can choose which invoices to borrow against, which provides greater flexibility than traditional loans
• Interest costs are low: Most invoices are financed for less than 90 days. Even with high interest rates, interest costs remain low because loan terms are short.
• Customers maintain confidence in the business: Customers won’t know their invoices are being financed. They simply pay their bills in the same manner they always have.

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But of course, there are some disadvantages of invoice financing:

• Fees tend to be high: While interest accumulation can be low, the fees often make up for it. Many invoice financing companies charge flat-rate fees of up to 5% of the invoice value.
• Some businesses struggle to get approved for financing: Companies with high concentrations of debt may find it difficult to get approved for invoice financing
• Less beneficial for businesses with low-dollar invoices: Invoice financing companies offer short-term loans based on specific invoices, which means that businesses with low-dollar invoices may not see the benefit or may find financing those invoices too administratively burdensome
• Collection risks are compounded: If a customer pays their invoice late or defaults, the business will rack up more interest charges and may struggle to pay off their loan

Invoice financing vs. invoice factoring

Invoice financing and invoice factoring are two financing options that expedite the receipt of cash that’s held up in AR, but they go about them differently. Invoice financing is when a business borrows against incoming invoices, and invoice factoring is when a business sells outstanding invoices to a third party (the factor).

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Let’s look at the differences between invoice financing and invoice factoring:

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Who qualifies for invoice financing?

To be eligible for invoice financing, you need to have good credit—but you also need to work with creditworthy customers. A financing company will only want to underwrite your loans if they know your customers pay in full and on time.

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Other than having creditworthy customers, you’ll also need to meet standard business loan criteria, like:

• Being in a strong financial position
• Having a strong enough cash flow to float the interest costs and fees associated with invoice financing
• Not being bogged down with debt payments

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Invoice financing is best for businesses that issue high-dollar invoices and have high operational costs. This includes manufacturers, construction companies, trucking companies, and healthcare providers, just to name a few. It’s also most used in the business-to-business (B2B) space because these companies tend to have long billing cycles.

Cost of invoice financing

When considering invoice financing, it’s important to compare costs. Each lender will do things a bit differently, but the two payment terms you’ll want to look at are:

1. The flat fee (typically a percentage of the invoice)
2. The interest rate

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In both cases, the smaller the number, the better. Other factors that could affect financing costs are:

• Industry: Financing companies consider some industries to be riskier than others and, therefore, charge companies in those industries higher rates
• Invoice terms: The more time you give your customers to pay their invoices, the longer you’ll have a loan outstanding, allowing more interest to accumulate
• Invoice amounts: Typically, financing companies charge higher rates for larger invoices
• Creditworthiness: As with all loans, you’ll likely receive a better rate if you have a good business credit score

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Remember: The invoice financing fees you pay ultimately reduce the total amount you receive from customers. Yes, those upfront funds boost cash flow, but they also reduce overall profits. Balancing your working capital requirements with profit goals can be tricky.

Is invoice financing a good choice?

Assuming you’re eligible for these types of loans, invoice financing is a great option for many businesses. Invoice financing might be right for your company if you:

• Need quick access to cash
• Have high operational costs
• Have substantial outstanding invoices
• Have reliable customers
• Have limited credit history
• Struggle to secure traditional loans

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But before you pursue invoice financing (or any other type of business financing), ensure your AR cycle is effective. Many finance automation tools can improve your billing cycle and simplify your accounts receivable process. These tools can also provide reports to help you make more informed decisions, including data that can help you determine whether invoice financing would be a good fit.

Improve cash flow and close your books faster with Ramp

Invoice financing is a useful tool to smooth out cash flow, but it’s not your only option. Ramp’s industry-leading corporate card can give you access to credit limits up to 30x higher than traditional business credit cards.

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You’ll also get access to a full suite of finance automation tools, including spend controls, expense categorization, and accounts payable automation features that help businesses close their books up to 8x faster. Ramp integrates with today’s most popular accounting software, giving you complete visibility into all your outstanding receivables.

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Try Ramp and see why customers save an average of up to 5% a year across all spending.