Some months ‘30 days’ feels like forever. Especially when cash flow isn’t as good as I’d like.
Let me guess: you need finance for some reason but you’re stuck waiting for customers to pay invoices?
You guessed it.
We should have a talk about invoice finance, another popular alternative funding model for small businesses.
I’m all ears.
So the idea with invoice finance is simple. You’re waiting for customers to pay invoices but you could do with the money now. With invoice finance you ‘sell’ your outstanding invoices to a third party, who will advance you 80-85% of the money owed with the rest coming when the invoices get paid.
Sounds perfect. Tell me more.
There are two main kinds of invoice finance: factoring and invoice discounting.
With factoring a finance company essentially manages your sales ledger and collects the money your customers owe you against outstanding invoices. You get a percentage of the total value of the invoice (often around 85 per cent) and then the remainder when the invoice is paid. In turn you pay interest - called a ‘discount charge’ - to the finance company and typically a service charge, based on turnover.
OK, factoring makes sense. What’s the deal with invoice discounting?
The big difference with invoice discounting is that the finance company won’t manage your sales ledger, you do.
They lend you a percentage of the total money owed on your outstanding invoices. When your customers pay the invoices, the money goes to the finance company thereby paying off your debt and you then get the residue from that invoice. This continues with you borrowing further funds against future invoices.
That sounds like just the kind of thing that can help my cash flow. Are there any particular advantages to either model?
The biggest advantage with both kinds of invoice finance is that your cash flow gets a healthy boost and you don’t need to wait until your customers pay. You can make sure that your suppliers get paid on time. You might even be able to negotiate a discount for paying them ‘early’.
One of the things people like about factoring in particular is that your sales ledger is taken care of as the finance company is running it for you. Given they have a vested interest in recovering the money your customers owe, they may also be prepared to check the credit of future customers so they’re satisfied they can pay, which reduces the risk of invoices going unpaid.
You mentioned “growing businesses” – why does it help them?
You need to pay your suppliers after 14 days but your customers are paying you after 30 days. That’s a cash flow problem which isn’t going to go away and with a growing turnover, is only going to get worse. Invoice Finance recognises this and is able to carry on growing in direct relation to the amount that you are owed.
And what are the downsides of invoice financing?
Clearly the invoice financing company wants to make its money so you’ll pay interest on the amount owed at any time, and usually a service charge as well. As always, make sure you read the small print and do your sums first. You will clearly sacrifice some profit.
Also be aware that invoice financing is primarily designed for “business to business”. If you customers are predominantly members of the public you will probably have to look elsewhere.
Also, as your invoices are committed to the finance company you may find it more difficult to find other sources of business funding, as part of your potential collateral is effectively unavailable.
So a little from column A and a little from column B. Is there anything else I need to bear in mind?
Let’s talk about factoring again. While it may be tempting to outsource the management of your sales ledger to a third party you should think about how this affects your relationship with your customers.
The fact that a third party is managing your ledger and is trying to recover monies may affect how your customers perceive your business, especially if the company is seen as being “pushy”. You have built a relationship with your customers which you, and them, value.
In contrast, one of the benefits of invoice discounting is that your customers need never know as the financing arrangement can be made confidential. As far as your customers are concerned, they are still dealing directly with you.
While you obviously have extra leg work to do compared to a factoring arrangement, you will still manage your own sales ledger – and control the relationship with your customers.
Another potential benefit I should mention, is that it can be cost effective to insure against bad debts as part of your invoice finance package
It is also possible to finance single invoices, rather than an ongoing arrangement to fund all of your invoices - this can be really handy if you have a specific or one-off need.
So the benefit of invoice financing is that money can be accessed quickly. But I need to weigh up whether I want to use factoring and outsource my sales ledger but risk that affecting my relationship with my customers…
… Or choose invoice discounting and manage the customer relationship. Whilst still receive the value of the invoices from your partner. Exactly so.