What is Invoice Financing & How Does It Work? [+Pros & Cons]

I’ll be totally honest: Until recently, invoice financing was a mystery to me. You see, numbers have never been my strong suit – I was always horrible at math – and without much context to the term itself, invoice financing definitely exudes … an ick. I have a feeling that you get what I mean.

But after doing some (very necessary) research, I quickly realized that invoice financing isn’t just about the digits. It’s also about fiscal accessibility and flexibility for businesses. Even more so, it’s a relatively straightforward and effective way for businesses to improve their cash flow. You just need to know how it all works.

In this article, I’ll share the ins and outs of invoice financing (and invoice factoring), why it can be an absolute game-changer for businesses, and how you can leverage its potential.

Let’s get started, shall we?

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In essence, invoice financing helps businesses get paid faster. It enables you to reinvest in your company and handle your expenses more efficiently. Ultimately, invoice financing can be a great start for businesses seeking ROI quickly.

Now, invoice financing sounds rather simple; in some ways, it is. It all depends on what systems you use, what invoice financing companies you partner with, etc.

If you’re looking to get set up with something that’s user-friendly ASAP, I recommend HubSpot’s Invoice Tracking Tool. It provides a great starter pack of resources to make invoicing less of a hassle.

Plus, if you need a bit more guidance through completing the process, you can also consult this step-by-step video for complete instructions on how to create your first (successful) invoice:

How does invoice financing work?

To really understand invoice financing, we need to dive deeper into its inner workings. Let’s go through the process together:

Step 1: You provide goods or services.

First, your business delivers a product or service to a customer and sends the customer an invoice.

Let’s say you’re a graphic designer who just completed a logo design project for a startup company. For your (amazing) services, you invoice this startup $5,000 for your labor.

Step 2: You submit the invoice and receive a cash advance.

Continuing with our graphic designer example, next you’ll submit a copy of the $5,000 unpaid invoice to an invoice financing company. The company assesses the invoice and provides you with a percentage of the invoice amount as a cash advance.

This percentage can be anywhere from 70% to 90% of the total invoice value. In this case, if the invoice financing company offers an 80% advance, you would receive $4,000 from the $5,000 invoice upfront.

This influx of cash can be used in whatever way you see fit: to cover operational costs, invest in new projects, pay personal expenses, or whatever’s needed.

Step 3: Your customer pays the invoice and you repay the invoice financing company.

Eventually, the startup pays the $5,000 invoice to you as per the agreed-upon payment terms. Then, you remit the $4,000 cash advance, as well as a predetermined interest fee, to the invoice financing company. For this example, let’s just say the fee is $250 (5% of $5,000). In total, you’ll be returning $4,250 to them.

Now, interest rates vary depending on the lender. However, most lenders will likely offer an interest rate between 1% and 6%. Typically (as demonstrated above), in an actual dollar amount, this fee could range from $500 to as much as an extra $1,000.

You’re probably wondering: Aren’t I losing money, then? Well, kind of.

With invoice financing, you are essentially getting a loan. When you do finally receive the expected $5,000 from the startup, you are technically keeping it. However, you’re also returning what you borrowed to the invoice financing company, plus interest.

Step 4: You retain the remaining portion of funds.

Once you’ve repaid the invoice financing company, you’ll keep the remaining amount, which is the actual profit from the startup project.

So, in short, even though you’ve given back $4,250, you’ve already received $5,000 from your client, so you profit $4,750.

To ensure that you get the full scope of what’s available to you (before you decide if it’s something you should pursue for your company), let’s next talk about another way to finance your invoices.

Invoice Financing vs. Invoice Factoring

Invoice financing and invoice factoring are often used interchangeably, but there are a few key differences between the two.

To fully understand the difference, check out the chart below:

In essence, with invoice financing, you take out a temporary loan for your unpaid invoice, while with invoice factoring, you sell your unpaid invoice to a third party for immediate cash.

For clarity purposes, here’s how invoice factoring works in greater detail:

Step 1: You provide goods or services.

Running back our graphic designer example from above, let’s say you’re a graphic designer who just conceptualized some swaggy merchandise for a B2C company.

Again, for your services, you invoice this company $5,000 for your labor.

Step 2: You submit the invoice and receive a cash advance.

Next, you’ll submit a copy of the $5,000 unpaid invoice to an invoice factoring company. The company then assesses the invoice and provides you with a percentage of the invoice amount as a cash advance.

Just like invoice financing, this percentage could be 70% to 90% of the total invoice value. In this case, if the lender company offers a 90% advance, you would receive $4,500 from the $5,000 invoice upfront.

This money, once it’s in your possession, can be used however you’d like for your own business (just do so responsibly).

Step 3: The invoice factoring company collects payment.

Now, here’s where things with invoice factoring start to differentiate themselves from the invoice financing process.

With invoice factoring, the invoice factoring company takes responsibility for collecting payment from your customer, not you. Instead, the invoice factoring company will likely charge a factoring fee to your B2C client, which is a percentage of the invoice amount.

The factoring fee (which is just like the interest fee with invoice financing) can vary per lender. Typically, most lenders will charge between 1% and 5%. The exact fee is decided by following factors:

Creditworthiness of the customer
Invoice amount
Market demand
Industry

For this example, let’s say the invoice factoring company charges a fee of 3%. This 3% fee will accumulate for every week it takes for the B2C company to pay the $5,000 invoice.

Step 4: You receive the remaining balance.

Finally, once the B2C company pays in the invoice, the factoring company will deduct its fees and remit the remaining balance to you.

If the B2C company took, let’s say, 3 weeks to repay the invoice, you’d receive $4,850 back.

This value is equal to the amount of the original invoice ($5,000) minus invoice factoring company fee(s) (3% of $5,000, which is $150) that were paid back by the B2C company.

So, while you do receive a cash advance upfront, you ultimately do pay a fee for this service. The factoring company profits from the difference between the cash advance and the total amount you repay.

At the end of the day, the choice to use invoice financing or invoice factoring is entirely yours. But if you’re looking for my opinion, I’d say that invoice financing is typically more ideal than invoice factoring. Here are my main reasons why:

Profits immediately go back to you
You maintain sole control over customer relationships
Potential for lower costs (while both invoice financing and factoring involve fees, invoice financing can sometimes be more cost-effective, especially for businesses with a strong credit history)

Invoice Financing: Pros

Like you would for any big business decision, it’s important to weigh the pros and cons of invoice financing (or invoice factoring) before setting things in stone.

Here are the upsides of invoice financing:

Pro #1: Quick cash access

By far, this is the biggest advantage of invoice financing.

By converting unpaid invoices into immediate cash, businesses can better manage their day-to-day operations. This early payment gives immediate liquidity, thereby giving businesses room to fulfill their commitments and invest in expansion.

Pro #2: Potential for growth

As I just noted, invoice financing permits businesses to invest in growth opportunities, such as hiring new employees or expanding product lines.

This ability to scale up means that when the business grows, so does its capacity to find funds to support growth.

Pro #3: Confidential and debt-free

Confidentiality – particularly with invoice financing – keeps customers unaware that their invoices are being financed, which helps maintain trust and relationships.

Additionally, invoice financing has no debt on-paper incurred. It’s not a literal loan, so it doesn’t add debt to the balance sheet, making it an attractive option for businesses looking to maintain financial stability.

Invoice Financing: Cons

Next, here are some cons of invoice financing:

Con #1: Reputation

Customer perception (especially through invoice factoring, which directly connects your client to a respective lender) might be affected if one relies on invoice funding too heavily.

This could potentially elicit negative thinking about the state of the company’s financial position, thus putting a strain on relations with important customers.

Con #2: Potential for debt (if mismanaged)

Understanding when and how to use invoice financing responsibly can be the difference between a temporary cash-flow fix and a long-term financial strategy.

If you rely too heavily on invoice financing, you could find yourself in a cycle of debt.

Con #3: Selective approval process

Not all invoices are eligible for financing. If your customer has a poor credit history, or if the invoice is too small or too large, it might not be accepted.

This can limit your options, especially if you rely heavily on a few key customers.

How to Get Invoice Financing

Now you’re probably wondering: So, how do I actually get my hands on this magical cash you speak of, Justina?

Believe it or not, my dear reader, it’s pretty straightforward. If you’re interested in pursuing invoice financing, here’s what you’re going to want to do:

Step 1: Assess your needs.

Determine if invoice financing aligns with your business’ financial goals and needs.
Consider factors like the frequency and amount of your invoices, your creditworthiness, and the industry you’re in. Really think about everything!

Step 2: Gather required documentation.

Prepare your business’s financial statements, including profit and loss statements, balance sheets, and tax returns.
Collect copies of your invoices, customer credit reports, and any other relevant documentation. Remember: Paper trails equal steady sales.

Step 3: Research invoice financing providers.

Look for reputable invoice financing companies or factoring firms.
Consider factors like fees, interest rates, and the ease of the application process.
Request quotes from multiple providers to compare terms and conditions.

Step 4: Apply for invoice financing.

Complete the application process, providing the necessary documentation.
Be prepared to answer questions about your business, financial situation, and the invoices you want to finance.

Step 5: Negotiate terms and conditions agreement.

Discuss the terms of the invoice financing agreement, including interest rates, fees, and repayment terms.
Negotiate for favorable terms based on your business’s financial health and the value of the invoices.

Step 6: Acquire funding.

Once the agreement is finalized, the invoice financing provider will advance funds based on the agreed-upon terms.
The funds can be used to meet payroll, pay bills, or invest in business growth.

Step 7: Manage your repayment (read this one twice!)

Repay the invoice financing provider according to the agreed-upon terms, typically when the customer pays the invoice.
Ensure timely payments to avoid penalties or interest charges.

Invoice financing for the Win?

All-in-all, the decision of whether or not to use invoice financing depends on your specific business needs and financial situation.

If you’re struggling with cash flow and can benefit from a boost, invoice financing might be a viable option. However, it’s important to weigh your options, clientele, and future financial goals carefully. Then, you choose a reputable provider and move forward with the cash advancement process.

Invoice financing is a tool, not a magic wand. Use it wisely to improve your business’s financial health and achieve your goals. Take my word for it.