Many small business owners are constantly walking a fine line between having enough cash on hand and facing a cash flow shortage. Money received from customers who pay on terms enters the company just in time. But if a few customers pay late, working capital can be depleted fairly quick, sending the business toward a financial crisis.
Late paying customers are something all businesses deal with. A 2017 report by EXIM titled 'Key Facts & Figures On Late Invoice Payments' found that 60 percent of invoices are paid late with six days late being the average. More disturbing is that 20 of invoices are paid two weeks late. For any business that doesn't leave room for late payments, they are virtually guaranteed to run into a cash flow crunch.
Allowing customers to pay on terms means you're always waiting for your customers to pay. Terms are a fact of doing business but when you need cash much quicker, what are your options? Small businesses know that getting a loan from a bank is usually a losing battle. There is another option, and its called invoice financing. In this article, you'll what invoice financing is and when it can be a feasible option.
What Is Invoice Financing And Why Should I Use It?
Invoice financing, sometimes called accounts receivable financing, provides a business with a loan based on the value of their outstanding customer invoices. The financing company will look at each customer's creditworthiness and determine how many invoices it will finance. If all of your customers are creditworthy, you'll likely receive financing for the full value of all outstanding invoices.
The business must still collect on customer payments. As each payment is collected, a fee is paid to the financing company. In some cases, the financing company integrates with the business' accounting software. This allows the validation of customer payments and fee deductions to occur automatically.
There are fees involved with invoice financing. Typically, you can expect to pay 1% - 3% per month of the financed invoices' value. For some businesses, that will be a high price to pay but if you don't have any other financing options, invoice financing can be a savior as it will provide immediate cash flow. There are no origination fees with invoice financing.
Comparatively, the 1% - 3% per month rate charged for invoice financing is about 12% - 36% respectively when annualized. Most credit cards charge a 20% - 30% annual rate. Basically, invoice financing is similar to using a credit card when looking at the cost. Invoice financing is much lower than a lot of the online business loan lenders or lines of credit, which can start at a 60% annual rate and go up to over 100%.
Who is invoice financing for? We've touched on this a little but if you have exhausted affordable lending options and need an immediate cash advance, invoice financing is certainly a viable option. It can be a lifeline for a business that can't wait for customer payments to come in.
Invoice Financing Vs. Invoice Factoring
If you are familiar with invoice factoring, you might initially think that invoice financing is the same thing but there are some differences between the two. The end result is the same - the business is leveraging the value of its outstanding invoices for immediate cash flow. The differences are in how invoice financing vs. invoice factoring provides financing.
We know that invoice financing works similar to a loan and that the business must continue collecting payments directly from customers. Invoice factoring involves a company called the factor. The factor steps into the role of collecting customer payments. This is one of the main differences between these two financing methods.
Invoice factoring also means the business must give up some control. The business owner will need to be ok with the fact that another company will interface with its customers. A side effect is that customers may wonder if the business is having financial difficulties. If the business owner lets its customers know ahead of time that there will be a temporary change in how payments are collected, he can reduce customer concerns about the business' financial health. The factor can also represent itself as an agent of the business, so it looks like a division within the business or at least closely tied to the business.
Another difference with invoice factoring is the cost. Invoice factoring can run from 2% to 5% per month of the outstanding invoices' value. Annualizing this rate means invoice factoring can be as high as 60% per year. This premium is paid because the factor is assuming the risk of nonpayment from customers. To help reduce unpaid invoice risk, the factor will have more stringent creditworthiness requirements of the business' customers than that of invoice financing.
Invoice Financing Vs. Term Loans
Getting a small business loan can be a challenge, as any business owner who has tried knows. There are lots of documentation involved, validations, requests of the same documents, and it just takes a long time. At the end of this arduous and lengthy process, many business owners are denied a loan.
Certainly, if you are facing a cash flow crisis, waiting months for a loan, only to be denied in the end is not an option. Given the higher rates of invoice factoring and its more disruptive payment collections method along with higher cost, invoice financing fits into a practical middle ground as a viable financing option for small businesses.
- Working capital can be depleted quickly if multiple customers pay late, which can send the business into a financial crisis
- Invoice financing provides a business with a loan based on the value of their outstanding customer invoices
- If you need an immediate cash advance, invoice financing is might be the right option for yo and your business
- Small business loans are also another option, however your business could have to wait months in order to receive the loan