Invoice Financing: Definition, Types, Examples, Benefits, & More!

If you’re a business owner, you know how tricky and challenging it can be to keep the money flowing and balance your business costs with your revenue. That said, a well-known method to help secure cash flow in your business is called invoice financing.

With invoice financing, startups can find a way to get additional funding quickly and safely for other expenses essential to their business.

There is more to learn about how invoice financing works, how it differs from invoice factoring, and the benefits and disadvantages that come with it.

So, keep reading if you’re interested in learning how you can use this type of short-term borrowing method to your advantage!

Key Takeaways

• Invoice financing is a form of securing financial aid from lenders by using unpaid customer invoices as collateral.
• Unlike invoice financing, invoice factoring offers higher capital rates to business owners and takes on the responsibility of collecting payments from customers.
• Some of the advantages of invoice financing for small businesses include stabilizing cash flow, flexible and fast financial approval, and retained B2C relations.
• On the other hand, the potential drawbacks of invoice discounting include added repayment costs, limited business owner protection, and additional financial liabilities.

What is Invoice Financing?

Invoice financing, also called ‘invoice discounting’ and ‘accounts receivable financing,’ is a type of short-term borrowing. It involves borrowing or loaning money against the unpaid dues on invoices issued to customers.

Simply put, the unpaid invoices are given to lenders or banks as collateral. Once the loan is approved, business owners typically get 75% to 80% of the invoice amount within 24 to 48 hours.

Lenders and business owners also follow a repayment schedule with an additional fee imposed and distributed on the loan amount.

Consequently, the customer’s payment is then used to repay the bank or lender for the loan. The lender also calculates and subtracts interest fees from the loan repayment and deposits the remaining balance into the debtor’s account.

The said borrowing method is quite common in startups and small businesses. Various industries and business types, including sellers of consumer goods, transportation, and construction, also use invoice discounting frequently.

Invoice discounting is also common in purchases or transactions where customers can pay in installments. Let’s say a customer or buyer purchases goods with a 15-day or 30-day invoice.

Depending on the duration of the payment, waiting for customers to pay their dues in full can negatively affect a business’s capital and finances. After all, a business won’t pause operations or stop accommodating other customers while waiting for a single customer to make their payment.

So, instead of waiting for the payment to be made in full, business owners borrow the unpaid amount to leverage and manage the gaps in their operational expenses. At the same time, invoice financing protects businesses from the possibility of outstanding payments and unpaid debt from delinquent accounts.

Invoice Financing vs. Invoice Factoring: 5 Key Differences

It is important to differentiate between invoice financing vs. invoice factoring. Invoice financing is often mistaken for invoice factoring, given their similarities in structure and purpose. But how do these two differ?

To start off, invoice factoring, or accounts receivable factoring, involves selling outstanding invoices to a third-party organization or a factoring firm. In response, the factoring firm pays an advance or a percentage of the invoice amount.

At first glance, the two financing methods seem quite similar, but their differences lie in the following details:

Financing Structure

With invoice financing, business owners use their customers’ invoices as collateral, and the lender disburses a portion of the invoice amount to be repaid by the business owner within a specific due date.

But, with invoice factoring, business owners sell their unpaid invoices to the factoring firm. The factoring firm then purchases the invoices, often at discounted rates, and sends an upfront advance payment.

Collection Method

Lenders collect payment for the loan amount from the business owners. Meanwhile, factoring companies collect the repayment fees from the customers.

Business owners shoulder the responsibility of collecting payments from customers while also ensuring they repay the lender on time. In contrast, the factoring firm assumes the duty of collecting unpaid dues from the customer.

Customer Involvement

The customer is not directly involved when it comes to the transaction between the lender and the business owner in an invoice financing setup. This is because the lender collects the loan amount from the business owner.

Meanwhile, the customer thinks they are paying the business owner for their product or service when, in fact, the business now uses their payment to repay the lender. In other words, the customer is not made aware of the lender’s role or involvement in their purchase.

But, with invoice factoring, the customer establishes a relationship with the factoring company because they need to redirect payment of their purchase from the business to the third-party firm.

Invoice Amount

Invoice factoring offers opportunities to get financed for larger invoice amounts. The reason behind that is that business owners don’t need to worry about collecting and conducting follow-up reminders on customers whose invoices are not yet fully paid.

On the other hand, invoice financing best suits invoices with smaller amounts because it makes repayment more manageable for the business owner.

Business Type

Invoice discounting suits business-to-customer relationships, while factoring invoices is better suited for business-to-business and business-to-government transactions.

Since factoring firms collect repayments from customers or clients in place of the business owner, there is a possibility that regular consumers may not be in favor of a different organization reaching out to them for their unpaid dues.

Conversely, fellow business owners, organizations, and government agencies understand the transactional and straightforward nature of purchasing and requesting financial assistance from each other.

Invoice Financing Process: How it Works

To help you distinguish invoice financing or discounting from accounts receivable factoring better, here are the essential steps in a typical invoice financing process:

Step #1. The business owner sends an invoice to the customer. The invoice often contains a manageable amount, with a specific number of days for the customer to fulfill the required payment.

Step #2. The business owner sends copies of their unpaid small business invoices to the lender to get financing while waiting for the customer to pay the invoice in full.

Step #3. The lender sends a percentage of the invoice amount, along with the payment terms and due date, coupled with the amount loaned to the business owner.

Step #4. The business owner fulfills their financial obligations to the lender. If a customer pays the invoice in installments, the business owner may use the payments to repay the lender gradually. Otherwise, they must ensure the customer pays their invoice on time to avoid incurring additional fees.

3 Pros of Invoice Financing

There are notable advantages to invoice financing for small businesses, such as:

#1. Stabilized Cash Flow

By using invoice financing to resolve the lack of funding for their operations, business owners essentially get to purchase supplies ahead of time, manage other expenses, or save money in case of an emergency.

Waiting for customers to repay their purchases or dues in full is simply impractical for small business owners. Not only is waiting for customer repayments counterproductive, but it also hinders opportunities for companies to generate more revenue and maximize their finances.

#2. Faster Approval Process

Unlike other types of invoice financing, invoice discounting involves borrowing from lenders and entails a faster approval process. As such, startups and small business owners get access to the funds they need within a shorter period of time.

Invoice factoring typically takes 30 to 90 days before it gets approved, leaving business owners with a huge gap in their budgeting plans.

#3. Retained Business-to-Customer Relations

Since lenders do not reach out to the customers to remind them of their payments, business owners get to protect and retain the established relationship they have with existing buyers.

Often, when small businesses have repeat customers, the former has already observed the latter’s purchasing and payment habits.

That said, the business owner also knows how to best communicate and remind customers of their payment responsibilities in such a way that it does not overstep the customer’s boundaries.

4 Cons of Invoice Financing

If there are advantages to using invoice financing to secure cash flow, there are also crucial cons or disadvantages that you need to be aware of, such as:

#1. Costs

When business owners get approved for accounts receivable financing, they also accept the responsibility of repaying the fees that come with the invoice amount they borrowed. Some lenders charge at least 1% to 5% in fees on top of the loaned invoice amount.

That said, business owners must be mindful of the unpaid invoice amount they wish to have the lender finance on their behalf. Otherwise, if the business owner loans an expensive amount, it might be difficult to repay their dues on time.

#2. Limited Protection

Aside from the added costs, business owners also have to deal with the limited protection they get from invoice financing. They do not have a third-party organization or a firm to handle the repayment duties for them.

If the customer does not pay their invoices, the business owner ends up facing heavier financial liabilities.

#3. Unpredictability

There are several factors that can add up to the final cost to be paid by the debtor or business owner. As such, business owners do not have a concrete idea of the total amount they must repay until the lender sends the invoice financing agreement.

Aside from the additional fees charged by the lender, there are also potential penalties that arise in the event of a customer’s late payment or non-payment.

#4. Financial Burden

Since invoice financing is the same as securing a bank loan, it adds financial responsibilities on the part of the business owner. Managing the workload that comes with invoice financing depends on whether customers are diligent in fulfilling their payment obligations.

Unless a business owner has a backup plan in place or accountants to aid them in tracking their expenses, balancing their financial responsibilities can be tricky and difficult.

Invoice Financing Example

Now that you know the definition, benefits, and potential drawbacks of using accounts receivable financing for your business, here’s an invoice financing example to use as additional reference:

Invoice Finance Tracking Made Easier With Paystub.org

Paystub.org offers an efficient solution to help you stay on track with your business expenses and financial responsibilities.

Whether you want to use invoice financing or invoice factoring to manage cash flow in your business, you still need an efficient tool to track and organize your invoices.

As such, our invoice generator is an online tool that lets you generate invoices for every transaction in a few minutes!

With invoice templates to choose from and a built-in calculator to do all the math for you, you can easily manage all purchases and transactions even with limited resources and manpower.

Issue invoices on time, track customer payments, and adhere to your lender’s invoice payment terms without breaking a sweat.

For a fully efficient and well-rounded business operation, we also offer tools designed to aid you in your payroll administration process. These tools include pay stub generators and generators for W-2 forms and 1099 forms.

Final Thoughts

Managing a business, acquiring new customers, boosting customer retention rates, and balancing your expenses with your revenue can be overwhelming. Not only does it require careful financial planning, but it also tests your resourcefulness, especially in times of crisis.

Invoice financing is a convenient way to generate funding for your business and fill in gaps in your capital. It gives you the security you need to address the demands of ensuring you retain your business operations and manage your liabilities efficiently.

That said, it is necessary to weigh the pros and cons of invoice financing with your business structure and customer type.

Take the time to assess your capacity to handle the financial burdens that come with using accounts receivable financing, and have a concise plan in place to guide you in repaying your dues.

Invoice Financing FAQ

#1. Why should you use invoice financing?

You should use invoice financing because it is a great way to boost cash flow in your business. Most businesses also use this method to collect extra funding in case of an emergency.

#2. Is invoice financing risky?

Unfortunately, invoice financing can be risky, particularly when clients are unable to pay their outstanding invoices. At the same time, some scammers may attempt to use falsified invoices to try and secure money from unsuspecting businesses or vendors.

#3. How do you use an invoice for financing?

To use an invoice for financing, you must submit the invoice for an unpaid purchase or service to a bank or lender so that the latter will provide a percentage of the net amount declared on your unpaid invoice.