Anyone in charge of running a business needs to be aware of the role cash flow plays given that it's one of the biggest aspects for determining how successful or how much of a failure a business is.
Unpaid invoices are one of the major contributors to these kinds of cash flow issues, and they tend to impact smaller businesses with fewer cash reserves the most.
The end result of months of slow, unreliable, customer payments is that your business becomes far less capable of meeting even the most basic of its financial needs such as paying employees or utility bills.
Yet there are plenty of ways to get over this kind of bottleneck so that you're able to (at least partially) bridge the gap between the goods and services your company has already provided and the payment for them.
One of the most effective of these methods is invoice financing, which involves a few options you may have already heard of, such as invoice discounting and factoring.
There are pros and costs with these services, and costs to be aware of, which we discuss in detail in this article.
Understanding invoice financing
Kicking things off, it's worth breaking down a few of the basics for invoice financing rather than just diving straight into the costs.
There are quite a lot of options available for securing finance as a business owner, but a lot of the more traditional options can have lengthy waiting times.
When even a couple of days can make a massive difference to your cash flow, you may not have time to wait. Invoice financing gives you an opportunity to use any of the unpaid invoices you're waiting on to gain access to immediate cash.
It's a process that involves you working with a third-party financial institution, known as an invoice financing company, and it will advance a percentage (which tends to be around 70-90%) of the total invoice value to your business.
The difference between invoice factoring and invoice discounting
Although you'd be forgiven for mistaking the two at first glance, each option has different implications, so let's understand what separates them here:
Invoice factoring
Invoice factoring is when your business sells its unpaid invoices to an invoice factoring company which takes on the responsibility of getting the customer to pay.
Now, it's worth noting that you're not going to be given the full sum here until the customer has actually paid the factoring company, but either way, you look at it, it's a major portion of your projected revenue becoming immediately available.
You'll pay a factoring fee for the service, which is usually a percentage of the total invoice value that's based on things like your customer's creditworthiness and how many invoices you want to be involved in.
Invoice discounting
Invoice discounting works in a similar way to invoice factoring, except your business keeps much more control over your sales ledger and the overall collection process with your customers.
So, while you're still borrowing money, you're the one who continues managing the invoicing and all of the collection tasks.
This means your customers are probably not even going to know about your financing arrangement since it's still your business that maintains direct communication when it comes to payments.
Yet, invoice discounting isn't without its fees, either — you can still expect to pay for interest and service fees.
Understanding service fees
The service fee is an inescapable part of the overall costs if you're considering using this kind of method to secure business finance, but what is the fee made up of?
Service fees: the backbone of invoice financing costs
Invoice financing is charged depending on the specific provider that you've gone to and it should cover things such as any administrative tasks the company needs to perform, as well as any other kind of credit management services.
This can include things like conducting credit checks on all of the customers whose invoices you are selling, managing your sales ledger, and handling the collection of payments.
It should go without saying that the more services you need as part of your agreement, the higher the overall service fee is going to be.
This is why it's important to take the time to calculate how much using the service will cost you and what exactly you're getting for your money.
Understanding invoice factoring costs
Let's break down some of these costs further:
Invoice factoring costs: factoring in the risks
The specific factoring fees you'll be charged will reflect the risk being taken by the invoice factoring company. If you deal with customers who have a strong credit history, you'll probably benefit from lower invoice factoring fees since the risk to the factoring company is lower.
Aside from the factoring fee, though, you've also got to consider the discount fee, which basically represents the cost of receiving immediate cash for their invoices. The discount fee is essentially the “price” the business pays for the quick injection of funds into its cash flow.
Invoice finance calculator
Since there isn't a uniform figure to give out in terms of how much invoice financing is going to set you back, you'll often find that the majority of businesses try to provide some tools so that you're able to work out some of the costs involved.
These tools can give you an estimate of all the potential costs that come with invoice financing (from that specific company) based on whatever specific circumstances you might have.
For example, if you add details such as the total invoice value, how much you'd ideally like as an advance percentage, and any additional fees to the calculator, you're going to get a much clearer picture of what potential costs are actually going to be involved.
Having said this the actual costs that you're going to end up paying are always going to vary based on the final terms you've negotiated with your provider.
Factors influencing invoice financing costs
To wrap up the article, let's finish on a few other features that may impact the cost of invoice financing:
Creditworthiness of customers
If you've ever tried to apply for a credit card, you'll know how important your creditworthiness is. Yet with invoice financing, it's the credit scores of your customers that play a role when it comes to working out your total costs. Any business that works with customers with relatively strong credit histories and payment records is generally more likely to be given lower factoring fees and interest rates.
Industry factors
The industry in which your business is operating can have one of the biggest impacts on how much invoice financing will cost and industries that inherently carry higher risks will tend to be more expensive.
Invoice financing can be an effective way of providing a quick cash injection when your business might be desperate, but this is definitely not a practice you want to actively seek out and it comes with fees.
Your customers might be slow at paying their invoices, but when you have to designate a portion of your monthly revenue to a third-party company so you can continue to stay operating, it's probably a sign that you're not very financially sustainable and may slip into insolvency further down the line.
