What is Invoice Financing? How Does it Work?

Invoice financing is a term that applies to a number of products that allow you to finance accounts receivable. The two most used solutions are factoring and asset-based financing. In this article, we discuss both solutions in detail.

Quick Summary

Factoring allows your company to sell its invoices to a finance company. The factoring company buys your invoices and provides you with an immediate payment. This payment provides funds to run operations and grow the business. Factoring is commonly used by small and midsize companies.

Asset-based loans provide a revolving line of financing secured by your accounts receivable. Much like factoring, this financing line improves your cash flow. Asset-based receivable lines are commonly used by larger companies. They are considered a stepping stone to getting a bank line of credit.

Both solutions provide similar end results to the client. However, they use different approaches and structures.  They also have a different cost. This article answers the following questions:

  1. What is invoice factoring?
  2. How does factoring work?
  3. How much does factoring cost?
  4. What is an asset based loan?
  5. How does an asset-based loan work?
  6. How much do asset-based loans cost?
  7. Which solution works best for your company?

What is invoice factoring?

Factoring is the simplest form of invoice financing. It allows companies sell their accounts receivable to a factoring company. In exchange, the client gets an immediate payment.  The funds can be used for any business purpose. You can:

  1. Launch new projects
  2. Hire employees
  3. Buy supplies –  or –
  4. Pay for company expenses

Most companies can get a factoring line established in a couple of days. Once the line is established, most invoices take a day to finance. This solution works well for companies that offer net-30 day terms to clients, but need to get paid sooner. Learn more about the advantages of factoring.

1. How to qualify for factoring?

Factoring is easier to get than conventional financing. This is because of it’s structure. Your company is selling an asset rather than getting a loan. To qualify, your company needs to:

  1. Have creditworthy commercial clients
  2. Be free of encumbrances (liens and judgement)
  3. Have good invoicing practices
  4. Invoice for delivered goods/services

Factoring is available to small and midsize businesses, including new companies and companies with few (if any) assets. Learn if you qualify for factoring.

2. How does factoring work?

Most transactions are structured as a two-installment invoice sale. The first installment payment covers about 80% of the value of your invoices. It is deposited to your account within one business day of requesting funds. Your company gets the remaining 20%, less the finance fee, as a second installment. This payment is provided once the customer pays the invoice in full.

Some transactions in the trucking industry are financed in a single funding instead. In this case, the factoring company finances the invoice in one advance of 95% – 98%.

Factoring lines are based on your sales volume. Therefore, lines can increase as your sales to creditworthy commercial clients grow. Learn more and about factoring and how to choose the best factoring company for your business.

3. How much does factoring cost?

The cost of most factoring lines range from 1.15% to 4.5% per 30 days. Lines can be structured in many ways, based on your situation. As an example, a line that averages 2% per 30 days can be provided as follows:

  • 0.67% per 10 days (0.67% x 3 = 2%)
  • 1% per 15 days (1% x 2 = 2%)
  • 2% for first 30, 0.67% per 10 after that

The actual structure is flexible and based in what works best for you an the factor. Learn more about factoring costs and typical rates (by industry).

What is an asset based loan?

An asset based loan allows you to finance your company’s assets. Usually, these assets include invoices, equipment, inventory, and machinery. In this article, we focus only in financing invoices, as this compares to factoring.

Asset based loans are considered an intermediate product between factoring and a bank line of credit. They are harder to get than factoring, but easier to get than a bank line of credit.

Like factoring, receivables asset-based financing loans use your invoices as collateral. This provides you with funds that you can use to pay for company expenses and new projects. However, the operation and setup is different.

Setting up an asset-based facility takes about three to four weeks. The actual time depends on the size and complexity of the opportunity. After setting the line, getting funds takes a day or two. Companies can request funds on a schedule that meets their needs.

Asset-based loans need much more documentation than a factoring line. Your company must have good financial statements and a track record of profitability. Asset-based loans work best for companies that invoice at least $750,000 per month. Learn more about asset-based financing.

1. How does a receivables-backed asset based loan work?

A receivables based asset based loan works much like a conventional line of credit. It allows your company to draw funds as you invoice clients. You pay the line down as customers pay their invoices.

On average, lines allow you to borrow up to 85% of the value of your eligible receivables. However, this varies based on your industry, client concentration, and A/R credit quality.

To access funds, the client must fill out a borrowing certificate. The certificate is used to calculate a borrowing base. The borrowing base determines how much funds you can get based on your financial situation.

The borrowing certificate lists outstanding receivables (and other assets). It then subtracts ineligible assets, and applies the resulting amount against your available line.

The operation of the line revolves around the borrowing certificate. Thus, your company must have an accurate and up-to-date accounting system. Asset-based loans can only be used by companies with established accounting departments.

2. How much do asset-based loans cost? (A/R only)

Asset based loans have two sets of costs. They have a due diligence cost and an operations cost.

The due diligence cost is paid upfront. It covers the costs of underwriting and originating the account. In some cases, underwriting may require onsite field audits. Due diligence costs range from $2,500 to $20,000. They vary based on the size and complexity of the transaction.

The operations cost is the actual cost of financing per se. It is based of prime rate, using what is called a “prime plus” structure (as in “prime plus X%”). Yearly rates go from around “prime + 3%” to “prime plus 7%“. This cost is around 8% to 14%  per year and varies with the prime rate.

Your company’s’ financing rate is based on sales volume and transaction risk. Generally, higher volumes and a diversified client base will get you the best price.

Which solution is the right one for your company?

Which product works best for you depends on a number of factors. They include your:

  1. Company size
  2. Financial strength
  3. Track record – and –
  4. Specific needs

Companies that need less than $500,000 of financing should focus on factoring. Companies that aren’t profitable, are in turnaround mode, or cannot pay the due diligence cost, should also consider factoring. Factoring has no (or minimal) upfront costs. Also, lines are easy to manage, relatively easy to get and quick to set up.

Companies that need between $500,000 and $750,000 are in a borderline situation. They could qualify for an asset-based loan in the right circumstances. However, factoring could be the most effective solution. Use the economics and operations complexity of both solutions to determine which works best for you.

Lastly, companies that need more than $750,000 and are in reasonable financial shape should consider an asset-based loan. This solution offers the best price, flexibility and control.

Looking for financing?

We are a leading provider of invoice financing. For a factoring or asset based loan quote, fill out this form or call us toll-free at (877) 300 3258. or call us toll-free at (877) 300 3258.