Invoice Financing Meaning
Invoice Financing is a process of financing the short term liquidity needs of a company by using their outstanding invoice dues, which are also called receivables, and such receivables are used to borrow the short term money from a bank or a financial institution.
Types of Invoice Financing
The following are types of Invoice Financing.
- Invoice Factoring
- Invoice Discounting
The major difference between these two types of financing is who (Lender or the company getting the money) is responsible for collecting the payments from the customers.
#1 – Invoice Factoring
This method is used to get the short term money by pledging its receivables to a lender. The lender is responsible for collecting the payments from the customers of the business.
As the lender is responsible for collecting the payments, the fees charged for this type of financing are slightly more than invoice factoring. The fees also include the due diligence charges which the lender does in order to measure the creditworthiness of the customers. Moreover, it is important for the customers to know that their payments will be collected by a third party lender and not the actual company which lends its products/services to its customers.
Example of Invoice Factoring
Invoice factoring is the simplest form of financing. It takes place in two stages. In the first stage, the company gets around 80% of its total invoice dues, and then when the entire payments are paid by its customers to the lenders, the lender returns the remaining 20% deducting its fees.
For example, consider company A has receivables of $5000, which is due in 90 days. So company A goes to a bank/financial institution B asking for invoice financing on its receivables and asks for money immediately rather than waiting for 90 days to get the money from its customers. B will check the creditworthiness for A’s customers, and with the due diligence checks, B decides to lend 85%, which is $4250 to A. Once B collects the entire $5000 from A’s customers, B will pay back the remaining 15% by deducting its fees. So B will return $550 to A and getting $200 as fees. So overall, A got to fund its working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)" needs quickly without waiting for its customers to pay its money back, and it got charged a fee of $200.
#2 – Invoice Discounting
Here the company which needs the money retains the collection of dues and gets money by showing their invoice dues. As the collection of money is still with the company, the fees charged to fund its short term liquidity needs are slightly lower as compared to invoice factoring. Here there is no due diligence charge because the process of collecting money still lies with the company. Though the lender does check the creditworthiness of the clients, the transaction happens majorly on the reputation and the financial strength of the company.
Example of Invoice Discounting
Here the company asking for money is responsible for collecting the payments from its customers.
For example, consider company A has receivables of $5000 with a due date of 45 days and is in need of quick money to funds its employee salaries. Company A goes to a bank B asking for quick money and shows its receivables invoices and agrees to pay a fee of 3%. Bank B lends 80% of the total receivables, which is $4000. So company A gets this $4,000 to funds it needs without waiting for 45 days. Then the customers of A pay back their dues of $5,000 to A. A then sends $4,150 to B and keeps the remaining with them. So overall B gets its own money back and 3% of fees on $5,000, which is $150.
Advantages and Disadvantages of Invoice Financing
Advantages of Invoice Factoring
- A quick and safe source of funds to carry out the working capital needs
- It can lower the time spent on administration and collecting payments because the lender takes control of collecting the receivables.
- The cheaper way to raise money as compared to equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule. and, moreover short term needs cannot be fulfilled by equity financing every time.
- Easier to get money in terms of tough credit markets.
Disadvantages of Invoice Factoring
- It can affect relationships with your customers because now a third party lender has taken over the control of collecting the payments.
- The costs are higher as compared to other bank loans, and it will also depend on the quality of your receivables and clients.
- It may reduce your chances of getting other types of loans.
- Loss of control as someone else is responsible for collecting the payments.
Advantages of Invoice Discounting
- Accelerates the cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. as you don’t need to wait for your customers to pay.
- No need for having other high-value collateral;
- It is done confidentially, so it doesn’t hamper the relationships with your clients.
- Easy to get money even though you may have been rejected for other types of loans.
Disadvantages of Invoice Discounting
- You still have the responsibility of collecting the payments.
- If in case the customers don’t pay on time, the fees might shoot up for late payments to your lenders.
Factors Responsible for Getting Invoice Financing
- Company size.
- Track record (Past History).
- Quality of clients from whom receivables are due.
- Financial strength in case the customers don’t pay back on time;
- Invoice practices.
There is no specific formula to decide which type of invoice financing a company should go for. It all depends on the kind of needs and the position of the company to funds its working capital needs. If a company does not want to waste time in collecting the payments, it can go for invoice factoring by paying some extra fees for saving time. If the company wants to retain the control of payment collection and just needs the money for its operations, it can go for invoice discountingInvoice DiscountingInvoice discounting refers to invoice financing where businesses borrow money as loans from finance companies by keeping the amounts due from customers as the collateral, accounts receivable is used as collateral, and finance companies, in return, issue the loan less than the amount receivable as per the invoice..
This has been a guide to what is Invoice Financing and its meaning. Here we discuss the two types of invoice financing along with its examples, advantages, and disadvantages. You can learn more about financing from the following articles –