Summary: Invoice financing, also known as invoice factoring, is a type of debtor finance that helps improve the cash flow of companies that have slow-paying invoices. This form of financing gives the client access to immediate funds, which can then be used to pay for business expenses and to grow.
In this article, we show you how invoice financing works. We go over every aspect that you need to know to determine if this solution is right for you. We cover the following subjects:
- How does invoice finance work?
- Setting up an invoice financing line
- Qualification requirements
- Is invoice finance right for you?
1. How does invoice financing work?
The process of financing your invoices is relatively simple. It’s structured through the sale of your invoices to a finance company. The finance company buys your invoices and pays immediately for them. Consequently, you don’t have to wait 30 to 60 days to get paid by customers. This provides your company with immediate access to funds while the finance company waits for your customers to pay.
Transactions settle once the finance company receives a payment from your customer. Your customer pays their invoices on their usual terms of 30 to 60 days. This solution provides an ongoing source of financing, improves liquidity, and provides a platform for growth.
Most invoice finance companies buy your invoices in two instalments. The first instalment is called the advance and covers about 80% of the invoice’s value. The advance is deposited in your bank account when you submit an invoice. Note that the advance percentage varies based on industry and risk profile and can range from 70% to 85%. The average advance is about 80%.
The remaining 20%, less the invoice financing fees, is paid once your customer pays the invoice in full. These funds are deposited to your bank account as a second instalment. This payment settles the transaction.
2. Setting up an invoice financing line
In this section we cover everything your company needs to do to establish an account and get financing. Setting up an account is a one-time process and usually takes a few days. After the account is set up, you are ready to finance invoices.
Invoices from existing customers can usually be financed the same day you submit them. However, these invoices must be submitted early enough during the day so the finance company can process them. Otherwise, invoices are usually financed within a day or so.
Step 1: Find an invoice financing company
Most invoice finance companies are small to medium-sized businesses that specialise in specific industries. It’s best to choose a company that has experience in your industry.
Work with invoice finance companies that have been in business for five years or more. This longevity shows that they have the financial wherewithal to survive economic cycles.
Step 2: Application and due diligence
The next step is to fill out and submit the financing application. Each company has its own application process, though they are all similar. Invoice financing companies need the application to evaluate the transaction and determine if it’s a good fit for both parties. During their due diligence, factors evaluate whether your:
- Customers have good credit
- Invoices are free from security interests
- Business has no major problems
Due diligence is usually quick, and you can often get a proposal shortly after you submit your application.
Step 3: Proposal and contract
The finance company will send you a proposal after they finish reviewing the transaction. Most proposals have three key pieces of information:
- Advance rate (1st instalment)
- Fee structure
- Length of term
Once you sign the proposal, the factor performs its final diligence and sends the contract to you. Once you sign the contract, your account is ready for first funding.
Read “How much does invoice finance cost?” to learn more about the fee structure.
Step 4: Initial account setup
In this step, the finance company sends a Notice of Assignment (NOA) to every customer whose invoices you want to finance. The NOA is a standard industry document and is used by every factor. It advises the customer’s accounts payable department on how to handle invoice payments. This process is done once for each customer.
Step 5: Financing invoices
Every finance company has its own submission process, though they are all similar. Usually, you upload the invoices you want to finance through an online portal. Once the finance company receives and verifies the invoices, they deposit the first instalment (advance) in your bank account. You repeat this step every time you want to finance invoices.
Step 6: Settling transactions
Invoice financing settle each transaction when your customers pay their invoices. Once paid, the factor remits the remaining 20% (less the fee) to you, as the second instalment. This deposit settles the transaction.
3. Do I qualify for invoice financing?
Qualifying for invoice financing is much easier than qualifying for other types of business financing. The main prerequisites are:
a) Your customers must have good business credit
This is the most important requirement to qualify for invoice financing. The transaction is built by leveraging the credit strength of your customers to your advantage.
b) Your invoices must be free of security interests
Invoice financing companies provide financing by purchasing the financial rights to your invoices. Consequently, your invoices must be free of security interests. Finance companies will buy only invoices for which they have a first position in a PPSR search.
c) Margins must be above 15%
It’s best to use this financing solution if your gross profit margins are at least 15%. If you are unsure, speak with your finance team.
d) You must have good invoicing practices
Good invoicing practices are also an important requirement for financing your receivables. Your invoices must have well-defined payment terms and must have all the necessary backups to ensure smooth collections.
4. Is invoice financing right for you?
Although easy to get, invoice financing is not for everyone. It is designed to solve a specific type of financial issue. You can determine if invoice financing will help you by asking yourself three questions. If any (or all) of these statements are true, invoice finance is probably the right solution for your company:
a) If customers paid quickly, your financial problems would go away
Most companies that finance their receivables do so because they have cash flow problems. These problems are always due to slow-paying customers. If getting paid sooner (through financing) would eliminate the majority of your financial problems, there is a good chance that this solution is right for you.
b) Customers keep asking for payment terms, but you can’t offer them
Small and midsize companies often experience problems when their larger customers demand 30- to 60-day payment terms. Their financial reserves are not large enough to pay company expenses while also waiting for customer payments. This puts them in a bind. They can either turn away customers or offer terms while getting into a financial predicament.
c) You have turned away orders because you could not afford to fulfill them
There are times when a company must turn new orders away because it does not have the resources to service them. This scenario leaves customers with no other choice but to go to a competitor. Obviously, you want to avoid this situation at all costs. This problem is common for companies that have growing payrolls (e.g., labour hire agencies, consulting companies, etc.)
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Marco Terry is the Managing Director of Commercial Capital LLC and has over two decades of experience in asset-based finance. He has worked with small and mid-sized companies across the United States, Canada, and Australia. Marco holds a Master of Science in Finance.