Published Jan 03, 2022

Invoice Financing: Everything You Need to Know

Table of contents

Invoice financing is a financing solution for businesses that need a quick cash injection. It is particularly useful for small business sellers negatively impacted by a long delay between sales and payment.
To help you determine whether invoice financing is suitable for your business, this article explains the details of invoice financing, including what it is, how it works, types and costs of invoice financing, as well as its pros and cons.

  • What is invoice financing?
  • How does invoice financing work?
  • Invoice financing vs. invoice factoring
  • Types of invoice financing
  • Costs of invoice financing
  • Pros and cons of invoice financing
  • When should you use invoice financing?
  • Is invoice financing right for your business?
  • Some last words

What is invoice financing?

Invoice financing is a  financing solution which helps you turn outstanding invoices into cash.

As companies get access to funding based on receivables, invoice financing is also known as invoice finance, accounts receivable financing or receivables financing.

How does invoice financing work?

In invoice financing, you can sell your outstanding invoices at a discount (i.e. invoice factoring), or use those invoices as collateral for a loan or line of credit. Either way, you will get access to cash earlier than the invoice due dates.

Invoice financing vs. invoice factoring

The terms “invoice financing” and “invoice factoring” both refer to financing solutions that involve unpaid business invoices, and are sometimes used interchangeably.

Strictly speaking, however, invoice financing and invoice factoring are not the same.

Invoice financing is a broader term which covers different types of financing instruments. Invoice factoring is a form of invoice financing.

To avoid confusion, this article proceeds on the basis that invoice financing and invoice factoring are two distinct concepts (as explained above).

Types of invoice financing

There are three types of invoice financing: invoice factoring, invoice discounting and accounts receivable line of credit. Although all these financing instruments are invoice-based, they are structured in different ways. 

1. Invoice factoring

Invoice factoring is also known as accounts receivable factoring or debt factoring. It is a process of sale and purchase, not lending and borrowing.

In invoice factoring, you sell your company’s outstanding invoices to a third party company (called a “factor” or “factoring company”).

The factoring company will give you 70% to 85% of the invoiced amount upfront, then collect payment from your customers when invoices are due.

Invoice factoring example

  • You have an outstanding invoice, the face value of which is $10,000.
  • A factoring company agrees to buy your invoice at a factor rate of 4%.
  • Initial cash advance is at 80%, remainder to be paid upon collection on invoice.

In this example, the invoice is sold at a 4% discount (i.e. $400), meaning that you will receive a total of $9,600 on the invoice.

To minimize the risks of customer default, the factoring company will only give you 80% of this amount upfront. The initial cash advance is therefore $9,600 x 80% = $7,680.

The remaining balance is then $9,600 − 7,680 = $1,920. This amount will be remitted to you after the customer pays on the invoice.

2. Invoice discounting

Invoice discounting enables you to take out a loan using unpaid invoices as collateral.

The loan amount typically ranges between 80% to 95% of the value of the invoices, which you will pay back (with interest) once you receive payment from your customers.

Invoice discounting example

  • You have outstanding invoices valued at $10,000. 
  • An invoice discounting company agrees to lend you 80% of the total invoice value.
  • The lender will also charge a fee (to cover its risks, interests and other costs). It will be repaid along with the capital.

In this example, you will be given $10,000 x 80% = $8,000 of cash. After you have collected on the invoices, you will pay back $8,000 plus the agreed fee to the lender.

3. Accounts receivable line of credit (AR line of credit)

In an accounts receivable line of credit, your business line of credit is collateralized by your company’s sales invoices. You will be given access to a pool of money, which you can withdraw anytime and repay with interest later.

Put simply, a line of credit works like a credit card. Withdrawal of money reduces the amount of available funds in your line of credit. Once the outstanding amount is paid back, the full amount will be available for you to use again.

Line of credit example

To illustrate how a line of credit works, below is an example assuming a credit limit of $250,000.

Costs of invoice financing

The costs of invoice financing come in many shapes and forms. While fee structures and amounts vary among financiers, here are some common fee items:

1. Origination fee

An origination fee may be charged for processing your loan application. It is usually assessed at a percentage of invoice value.

2. Credit check fee

Prior to making advances to you, factoring companies usually make credit checks on your customers in order to gauge default risks. The costs of credit checks may be passed on to you.

3. Factor fee

Factor fee calculation is straightforward. When you sell an invoice to a factoring company, a factor rate (usually 1% to 5%) will be applied to the invoice value. The amount kept by the factoring company is a factor fee.

4. Interests

Interests accrue on loans that you take out, and the amount drawn on a line of credit.

5. Service fee

Sometimes known as credit management fee, a service fee may also be charged by the lender for setting up and managing the credit facility.

6. Collection fee

If the factoring company is responsible for collecting payment from your customers, there will likely be a collection fee.

7. Overdue fee

Factoring companies may charge an overdue fee from you if your customers fail to pay on invoices past due.

Pros and cons of invoice financing

Advantages of invoice financing

1. Improve cash flow

Invoice financing gives you access to cash quicker than your invoices’ net terms. There is no need to wait for 60 or 90 days in order to get the cash from sales.

2. Outsource payment collection

Upon ‘buying’ your invoices, factoring companies usually take on the responsibility of collecting money from your customers.

This frees up your time, allowing you to focus on your business operations without distractions. It also saves you from the dirty work of chasing after customers for repayment, helping you maintain harmonious customer relationships.

3. Less stringent requirement on collateral

Conventional forms of lending usually require the use of cars, equipment or real estate as collateral. Invoice financing makes borrowing easier for small businesses which do not have a lot of expensive assets.

4. Less emphasis on your company’s credit history

In invoice factoring, your customers are the ones who pay factoring companies, whereas in invoice discounting, your ability to repay a loan depends on whether your customers pay you.

Therefore, financiers care more about your customers’ financial behaviour than your own. If you are a small business without a strong credit history, access to funding should not be difficult given that you have a creditworthy clientele.

Disadvantages of invoice financing

1. Could be very expensive

Invoice financing is one of the most expensive financing options for small businesses.

In addition to factor fees (in invoice factoring) and interests (in loans and lines of credit), there are multifarious fees which would greatly increase the cost of capital.

2. Application could be time-consuming

To apply for invoice financing, there is a lot of paperwork you need to prepare. The application process therefore requires a considerable amount of back-and-forth communication with the financier.

3. Possible deposit account control agreement (DACA)

In invoice financing, you may be asked to switch your company’s bank account to the financier. Alternatively, there may be a deposit account control agreement (DACA), in which the financier gets security interests in your DACA bank account.

4. Negative impact on customer perception

With factoring companies contacting your customers to collect money, your clients will know you have factored their invoices.

This may give rise to the impression that your company is experiencing cash flow issues, which is undesirable.

5. Less control over debt management

The flip side of outsourcing payment collection is that you will lose control over the debt collection process.

Having strangers track down your customers for payment may not leave a good impression on your clients, especially the important ones.

When should you use invoice financing?

Invoice financing can be used by small businesses to unlock money tied up in receivables. Below are some scenarios in which invoice financing would be helpful for your company.

1. You sell to large clients on credit

Working with large clients cuts both ways.

On the plus side, they could be a reliable source of revenue. On the minus side, big customers have more bargaining power (especially against small business sellers) to demand credit sales on longer payment terms.

While a long delay between sales and payment may not cause trouble to large business sellers, smaller companies may find themselves short of cash.

Let’s say you have to pay back your supplier for a large order for which your customer has not settled payment. You could use cash reserves to pay the supplier, but it is only a last resort as you want to maintain your company’s liquidity position.

Invoice financing would be helpful in this scenario. Leveraging the unpaid invoice to get access to cash, you will be able to repay the supplier without harming your relationship with the client or sacrificing your company’s cash flow.

2. You come across a window of opportunity

In this day and age, opportunity waits for no man.

For instance, there is an unexpected demand spike for your company’s products. The opportunity could only be captured by stocking up on inventory, increasing ad spend or even adding new staff to the warehouse.

When a good opportunity stands, the last thing you want is to have financial restraints preventing you from monetizing it. By freeing up the money in your receivables, invoice financing enables you to quickly invest in your company’s operations and growth.

Is invoice financing right for your business?

The past decade has witnessed a boom in new and innovative business models across the globe. In answer to the needs of budding businesses, a wide range of financial instruments have emerged to provide funding in varying ways.

When managed properly, invoice financing is helpful for closing cash flow gaps in small businesses. Yet, the complex fee structure is something to be wary of — miscellaneous fees could put a huge price tag on the money you get.

Furthermore, the way that trade finance applications are processed make them time-consuming and prone to human error.

For new-age businesses that need quick and inexpensive funding, invoice financing may not be your best pick.

Alternative to invoice financing: Revenue-based financing

At Choco Up, we offer revenue-based financing (RBF) to fast-growing companies with a simple fee structure and flexible repayment.

In revenue-based financing, funding is advanced in a lump sum. Unlike loans, which require periodic repayment in fixed sums, RBF funding plus a small flat fee is paid back through a percentage of your company’s monthly revenue.

As Asia’s leading RBF platform, Choco Up has helped hundreds of businesses grow and scale with RBF funding. Here is what they like about revenue-based financing.

1. Quick access to funding

When it comes to growth funding, speed is an important consideration.

Understanding the needs of fast-growing companies, Choco Up provides a streamlined application process.

Simply by filling out an online application form, you could get a preliminary offer in 15 minutes. If everything goes well, funding could be available in as little as 48 hours.

2. Flexible repayment

Regular debt repayments could impede cash flow and hinder growth.

With Choco Up’s revenue-sharing model, you will repay more if you earn more, repay less if you earn less in a particular month. There is no pressure to get together a certain amount of money every month to fulfill your debt obligations.

3. Simple fee structure

With revenue-based financing, the only cost of capital is a small flat fee. There are no interests on the outstanding balance or miscellaneous fees hidden in financing agreements.

4. Non-dilutive

Revenue-based financing is a founder-friendly financing option as Choco Up does not take equity from your company.

Learn more: What is Revenue-Based Financing? Here is Everything You Need to Know

Invoice financing vs. revenue-based financing

Like invoice financing, revenue-based financing is one way to help your company smooth out cash flow issues — but with less fees, more flexibility and higher efficiency.

Below is a table comparing invoice financing and revenue-based financing to help you evaluate their pros and cons:

Invoice factoring Invoice discounting Accounts receivable line of credit Revenue-based financing
Availability Businesses with outstanding invoices Businesses with revenue
Collateral Not required Invoice Invoice Not required
Application process Slow Fast
Deposit account control agreement (DACA)? Maybe No
Fees Many fees (e.g. factor fee, service fee, collection fee, etc.) Flat fee only
Interest on outstanding balance? N/A Yes Yes No
Repayment N/A Fixed sum Variable (depends on amount withdrawn) Variable (percentage of monthly revenue)
Equity dilution No

Some last words

As an alternative to invoice financing, the distinguishing feature of revenue-based financing is its clarity in fee structure — just a small flat fee, nothing more.

It is also well-liked by high-growth businesses for its seamless application process and flexible repayment model, which enable companies to get funding quickly and invest in growth without worrying about debt obligations.

To learn more about what we do, check out our client success stories or apply for funding now!