SME Business Guide
Businesses that issue invoices can often face several cash flow challenges. One of the most significant issues is delayed payments from customers. Even though invoices are issued promptly, customers may take longer than expected to pay, causing a gap in cash flow.
Businesses can stay on top of cash flow issues with a cash injection from invoice finance. Invoice finance essentially allows the business to release cash against outstanding invoices before they’ve been paid. Invoice finance allows the business to release up to 90% of the invoice amount quickly, usually, within 24 - 48 hours. When the invoice is paid, the business receives the rest of the outstanding amount minus any associated fees from the lender.
There are two types of invoice finance; Invoice discounting and invoice factoring. These types of invoice finance operate differently and cater to different business needs. Here's a comparison of the two:
Invoice Factoring
Ownership of Invoices: In invoice factoring, the factor purchases the invoices outright from the business. The factor takes over the responsibility of collecting payments from the customers.
Customer Interaction: Since the factor owns the invoices, they typically handle the collections directly with the customers. This means the customers are aware that the invoices have been sold to a third party.
Confidentiality: Invoice factoring is generally disclosed to the customers. The factor communicates with the customers regarding payment collection, which may impact the relationship between the business and its customers.
Risk Transfer: The factor assumes the credit risk associated with the invoices. If a customer fails to pay, it's the factor's responsibility, not the business's.
Invoice Discounting
Ownership of Invoices: In invoice discounting, the business retains ownership of the invoices. Instead of selling them outright, the business uses them as collateral to secure a loan or line of credit from a financing provider.
Customer Interaction: Since the business retains ownership of the invoices, it continues to manage the collections directly with the customers. The customers may not be aware of the financing arrangement, as the business maintains control over the invoicing process.
Confidentiality: Invoice discounting can be kept confidential from customers. Since the financing arrangement is between the business and the financing provider, there's no need to disclose it to customers.
Risk Management: The business remains responsible for the credit risk associated with the invoices. If a customer fails to pay, the business must still repay the financing provider.
In summary, the key differences between invoice factoring and invoice discounting lie in ownership of invoices, customer interaction, confidentiality, and risk management. Invoice factoring involves selling invoices outright to a third party, while invoice discounting involves using invoices as collateral for a loan or line of credit while retaining ownership. The choice between the two depends on factors such as the business's cash flow needs, customer relationships, and risk tolerance.
Benefits of Invoice Finance
Improved Cash Flow: Invoice finance provides businesses with immediate access to cash. This addresses cash flow gaps and ensures that the operations can continue without the need for the customer to pay.
Flexible Finance: Invoice finance can be more flexible than traditional financing options. The amount of funding available is directly linked to the value of outstanding invoices, allowing businesses to access funds based on their sales volume. Additionally, it can be used as needed, providing on-demand financing without long-term commitments.
Seize Opportunity: Having a boost of cash flow gives the business the leverage that it needs to seize an opportunity as it arises.
Supplier Discounts: Invoice finance allows a business to avail of supplier discounts through early payment or the opportunity to take advantage of bulk discounts.
Drawbacks of Invoice Finance
Fees: Depending on the invoice finance type and lender, invoice finance can be expensive. Invoice finance providers typically charge fees for their services, including discount fees, processing fees, managing fees and interest charges. These costs can add up over time and reduce the overall profitability of the business.
Confidentiality: In invoice factoring arrangements where the financing provider communicates directly with customers, there may be concerns about confidentiality. Businesses may prefer to keep their financial arrangements private to maintain a professional image.
Risk of Bad Debts: In invoice discounting, the business retains responsibility for collecting payments from customers. This means the business bears the risk of non-payment or bad debts, which can impact cash flow and profitability.
Complexity and Administrative Burden: Managing invoice finance arrangements can be complex and may require additional administrative effort. Businesses may need to ensure accurate invoicing, reconcile payments, and communicate effectively with the financing provider, adding to the workload of finance and administrative staff.