By Alex Kyrioacou, is Head of Finance at Business Expert, a financial comparison website for businesses.
As a popular form of alternative finance, invoice finance is the ability to sell unpaid invoices to a third party in exchange for a percentage of their value. It’s a useful means of improving the working capital cycle but is it right for your business?
What are the Advantages of Invoice Financing?
- Improves the Working Capital Cycle – Managing cash flow is one of the biggest challenges for any business. Invoice financing allows companies to be paid quicker, freeing up cash flow.
- It Allows businesses to plan ahead– Borrowers benefit from the time and cost advantages of borrowing against future payments; they can plan better when seeking new customers or manufacturing new products.
- It Encourages business innovation – Greater working capital means you can spend time innovating, rather than chasing invoices. As many factors will actually collect the invoices for you, it can even free up human resources.
- It Protects businesses assets – Unlike traditional finance that might require personal guarantees, Invoice financing does require your business to put up assets as collateral. In fact, the invoices are the collateral in this arrangement.
- Greater Confidence for Large Contracts – For a small business, entering into a large contact with a big corporate can be risky. Huge amounts of working capital get tied up and the larger business can be slow to pay and impossible to speed up. Invoice finance gives you the confidence that you can get paid right away, regardless of payment terms.
- Better Credit Management – Because invoice factoring companies often take over the credit management, small companies can benefit from their experience and resources in this area, while freeing up time for other areas of the business.
What are the Disadvantages of Invoice Financing?
- It Costs More than Traditional Financing – Invoice Financing Companies charge a fee that typically includes a flat rate of 1% to 5% of the invoice amount. Banks typically offer more favourable terms when lending money against anticipated future income compared with when doing so against current income.
- It Requires Robust Credit Management – If you’re considering invoice financing, you should be willing to take control of the credit management aspect. Invoicing finance companies want to see robust credit management policies and procedures when measuring the risk of financing businesses. They also want to see competent and trained credit control staff and regularly review the business to ensure policies and procedures are in place.
- You are still liable for unpaid invoices – In most cases, you will still be liable for your customers unpaid invoices which could mean you have to pay back the funds you’ve been advanced if they don’t pay.
- Could affect your reputation – Because some factors insist on collecting the invoices themselves, your client base may become aware of your use of a factoring service.
Should My Business Use Factoring?
Factoring is certainly a decision you should weigh up carefully before embarking upon. For a business with multiple low value invoices and a relatively low profit margin, it likely won’t work at all. More likely, factoring is the right move for a business with few invoices and a high profit margin. In these scenarios, there is plenty of space to absorb the invoice finance fees without negatively impacting the overall business model.
The key benefit of factoring comes with the freeing up of the cash-flow cycle. It can be a hard drug to stop taking, so always consult your financial advisor or accountant before taking the plunge.