What is Invoice Financing and How Does it Work?

Invoice financing is a way for businesses to quickly release a chunk of the cash tied up in their unpaid invoices. 

Used correctly, invoice finance could provide your business with some of the money your customers owe you without having to wait weeks or months for them to pay up. This, in turn, can ease pressure on your cash flow – allowing you to handle routine expenses like payroll or meet unexpected costs.

Depending on the invoice finance arrangement, a typical finance provider may advance your business as much as 95% of the value of your unpaid invoices within 24 hours.

But since there are different types of invoice financing – and since the details of any arrangement are likely to depend on your business circumstances – the specifics of invoice financing may vary from one business to another. 

That’s where our free invoice finance eligibility checker can help. Simply provide some basic information about your business and how much money you need, and we’ll match you with eligible invoice finance providers in seconds. 

Otherwise, read on to learn more about how invoice finance works and how it could help your business. 

What is invoice financing?

Invoice financing is a way for businesses to quickly release some of the money tied up in their unpaid invoices. 

It’s an increasingly popular solution for businesses struggling with cash flow, with an estimated 45,000 UK businesses already using some form of invoice finance. 

Rather than borrowing against property or other business assets – like with a traditional secured business loan – many invoice finance providers will use your unpaid invoices as security.  

The finance provider will release an agreed percentage of the value of these invoices as an advance payment, giving your business fast access to finance when you need it.

When your customers settle their accounts, not only will the finance provider be paid back (the money advanced to you) but you will also receive the outstanding amount of the unpaid invoice. At this point, you’ll also pay a fee for the invoice finance service. 

There are three main types of invoice financing: invoice factoring (also called debt factoring), invoice discounting, and selective invoice finance (SIF). Each type of invoice financing works in a slightly different way.

How does invoice financing work?

Debt factoring (or invoice factoring)

Debt factoring (also known as invoice factoring) involves a business selling its accounts receivables – the money the business is owed by its customers – to a third party.

The buyer will likely either be a dedicated factoring company or a financial services company with a factoring division. 

Say you decide to sell some of your unpaid invoices to a debt factoring company as part of a factoring arrangement. 

The debt factoring company will pay your business a sum of money up front. Exact figures will vary depending on your business circumstances, but it is common for advance payments to be 80% – 95% of the value of the invoices you’re factoring. The advance is often paid quickly: sometimes within just 24 hours. 

Instead of your customers paying you directly, the factoring company will now collect your customers’ payments on your behalf. This means your customers will know that your business is using invoice factoring.

The factoring company will charge your business a factor rate for this service. This is a fee which may vary from 0.5% to 7% of the total value of the invoices you’re selling. It is likely to be charged on a weekly or monthly basis until all outstanding invoices have been paid to the factoring company. 

Some factoring companies may charge other fees, such as service fees and set-up fees, on top of the factor rate.

When all the outstanding invoices have been paid by your customers, the factoring company will pay you the difference between the value of the invoices and how much they paid you up front, minus fees. Ultimately, your business gets paid quicker, but you will end up receiving less money than if you had simply waited for your customers to pay their invoices.

Debt factoring is generally more popular with smaller businesses, as it is often easier to secure funding from a factoring company than through other means of acquiring finance. 

Invoice discounting

Invoice discounting is very similar to invoice factoring, albeit with one key difference. With invoice discounting, your business does not give up control over collecting customer payments. 

If you use invoice discounting, your business will still be able to borrow money against unpaid invoices, typically releasing up to 95% of the value of these invoices within 24 hours.

However, unlike with invoice factoring (where the factoring company assumes control over your sales ledger), with invoice discounting the responsibility for collecting your customers’ payments on time remains with you.

After your customers have paid what they owe, you will then repay the finance company the amount they advanced you – plus interest or fees. 

Invoice discounters will not credit check or interact with your customers – meaning your customers won’t necessarily know that you are using invoice discounting. 

This kind of invoice finance is generally more popular with established businesses and businesses with a higher turnover.

Selective Invoice Finance 

Invoice financing arrangements may be ongoing, with the factoring company or invoice discounter collecting debts from multiple customers over a long period of time. 

Alternatively, your business may be able to access invoice finance to cover single invoices on an ad hoc basis – without signing up to a long-term agreement. This is known as Selective Invoice Finance or SIF.

When invoice factoring covers a single invoice – rather than the whole sales ledger – this may also be referred to as spot factoring. 

While SIF is a more flexible approach to invoice finance, it may be more cost effective for your business to use conventional factoring or discounting if you would like to release the money tied up in multiple invoices. 

What are the advantages of invoice financing?

Invoice financing could free up cash much sooner than waiting for your customers to pay what they owe. 

You can spend this money on anything from paying staff wages to developing your growth plans. And as your revenue increases, the availability of finance for working capital does too.

A specific advantage of debt factoring – which involves outsourcing all responsibility for your sales ledger – is that you can use the time you would have spent chasing customer payments to focus on other areas of your business. 

Invoice discounting, meanwhile, has the advantage of being a more discreet choice – since your customers won’t ever have anything to do with the invoice finance company and won’t know that you’ve been borrowing money against their invoices.

What are the disadvantages of invoice financing?

Invoice financing doesn’t come free. 

If you enter into an invoice financing arrangement – regardless of whether you use discounting or factoring – the lender’s fees mean you won’t receive the full value of the invoices you’re financing. 

The result of the various fees associated with invoice finance is reduced overall profits in the long run. This means that generally speaking, invoice finance isn’t a long-term solution to business cash-flow problems.

Also, be aware that invoice finance providers will carry out credit checks on your business when you apply for finance. Multiple “hard” credit checks over a short space of time are likely to temporarily harm your business credit score.

A specific disadvantage of invoice factoring is that if your customers don’t pay their debts, the invoice finance provider may hold you accountable for the shortfall. This kind of arrangement is known as recourse factoring.

Non-recourse factoring – where your business won’t be held responsible for non-payment of customer invoices – generally incurs higher fees than recourse factoring.

With invoice factoring, your finance provider will also collect your customers’ payments directly, so your customers will be aware of your factoring arrangement. This may affect your reputation and any relationship you’ve built with your customers. 

Which type of invoice financing is right for my business?

All types of invoice financing can provide quick access to a portion of the money owed to your business. 

If you want to quickly check your eligibility and be matched with leading invoice finance providers, remember that you can always turn to our invoice finance eligibility checker. 

Is debt factoring (or invoice factoring) right for your business?

With debt factoring, the factoring company will take control of the sales ledger operations of your business. 

Your business will be paid a percentage of the value of all factored invoices up front as an advance. 

After paying the advance, which may be as much as 95% of the invoice value, the factoring company assumes all responsibility for collecting the money owed by your customers. 

When all outstanding invoices have been paid, the factoring company pays the business the rest of the invoice value, minus the factoring company’s fees. 

Is invoice discounting right for your business?

Invoice discounting is similar to invoice factoring in many ways. With invoice discounting, a business can borrow money against their unpaid invoices at an agreed percentage of the overall value. 

The main difference with invoice discounting is that the finance provider doesn’t manage the business sales ledger or provide debt collection services. This means your business maintains control of issuing reminders and collecting payments. 

It has been estimated that as many as 1% of all UK businesses use invoice discounting.

Is selective invoice finance (SIF) right for your business?

With selective invoice finance (SIF), sometimes known as spot factoring, you choose which specific invoices or customer accounts you want to finance on an ad hoc basis. 

SIF is a more flexible option if you’re not looking to outsource your whole sales ledger. 

What businesses are eligible for invoice finance?

Your business will usually need to meet certain eligibility criteria to access invoice financing. 

For one thing, most invoice finance providers will insist on a minimum annual turnover. 

Invoice finance providers also generally like to see that your business has an established trading history.

Furthermore, invoice finance will only be suitable for businesses that sell to other businesses on credit terms (i.e. – your customers are other businesses and you use invoices to bill them).

How to apply for invoice financing

If you think your business would benefit from invoice financing, start by checking your eligibility and comparing the providers available to you. 

You can quickly and easily check your eligibility and weigh up the pros and cons of various invoice finance providers with NerdWallet’s invoice finance comparison tool. If you’re matched with a suitable provider, you can then get a quote and apply. 

How much does invoice financing cost?

Invoice financing isn’t free, and your business will have to pay to access the quick capital offered by invoice finance providers. 

Rather than paying for this service up front, any relevant fees will be deducted by your finance provider after your customers have paid their invoices – meaning you’ll end up with less money in the long run than if you had simply waited for your customers to pay up. 

Fees vary between different providers, and what you pay is likely to depend on a number of factors, such as:

• your business sector and trading history
• the value and volume of your invoices
• how many customers you have
• how reliable your customers are
• how much you want to borrow

If you use invoice discounting, you’ll pay a discounting fee for releasing the cash. You can think of this as being similar to the interest you’d expect to pay on a bank loan. 

Discounting fees are charged as a percentage of the value of the invoices you want to finance – typically 1.5% – 3% over the base rate of interest. You can expect to pay a discounting fee once for every invoice you want to finance.

If you use invoice factoring, on the other hand, you’ll pay a factor fee. 

They are likely to vary depending on your business circumstances, but factor fees are commonly 2% – 5% of the value of the financed invoices. You can expect to pay this fee on a monthly basis until all your customers have paid up.

You may also have to pay a service fee for setting up an invoice finance arrangement. 

For a medium-sized business with an invoice discounting arrangement, a typical service fee would be around 0.2% – 0.5% of annual turnover. 

Depending on your invoice finance arrangement, you may also face additional costs – like an early termination fee if you want to end your agreement early or credit check fees to cover the cost of assessing the risk of lending to your business. 

In all cases, it’s crucial to read the terms carefully and to make sure you understand how much invoice finance will cost you before entering into any agreement.

How much can I borrow with invoice finance?

The specifics of how much you can borrow will depend on your business circumstances and the type of invoice finance you’re looking for. 

The amount of finance you can access will ultimately be a percentage of the total value of your outstanding invoices, so you can’t use invoice finance to borrow more money than you’re already owed. 

With invoice factoring, you may be able to access between 80 – 95% of the value of your unpaid invoices. 

And with invoice discounting, you may be able to borrow 90% – 100% of the value of your unpaid invoices.

How long does it take to access invoice finance?

A key advantage of invoice finance is that the money can land in your business bank account very quickly. 

Many invoice finance providers say they’ll advance the money within 24 hours, with some firms offering same-day funding and advances in a matter of just a few hours.

Can you get invoice finance with bad credit?

The specifics of any invoice finance arrangement are likely to depend on your circumstances, but it is possible to access invoice finance if your business has a poor credit score. 

This is because invoice finance providers are likely to be more interested in the creditworthiness of your clients – since it’s their money which will be used to repay any loan or advance secured against your unpaid invoices. 

However, even if a poor business credit score isn’t a barrier to accessing invoice finance, it may affect the terms of any arrangement you’re offered. 

With that in mind, remember that you can always use NerdWallet’s invoice finance eligibility checker to quickly get a sense of what invoice finance products may be available to your business. 

Alternatives to invoice finance 

If you’re looking for funds to help grow your business or take some of the pressure off your cash flow, invoice financing isn’t the only option. 

Other types of small business financing include:

• business loans and start-up business loans
• business credit cards
• asset financing
• peer-to-peer lending
• business bank account overdrafts
• small business grants

It’s important to research your options carefully and consider affordability before deciding which type of funding is best for your business. 

Do a cost-benefit analysis before taking out any loan, and be clear about the total interest you would be paying – in addition to any other fees or charges.

Image source: Getty Images

About the Author

George Harrison

George Harrison is a lead writer at NerdWallet. A graduate of the London School of Economics, George has worked as a professional writer for almost a decade, with articles appearing…

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