What is Invoice Financing and How Does It Work?

As every business person knows, there can be a big, long gap between revenues and actual cash flow – especially when you have customers who demand “generous” payment terms and wait until the last day to remit.

One way to bridge that gap is by borrowing against the value of the invoices you’ve issued… a procedure called invoice financing. What is invoice financing? How does invoice financing work? Is it a good fit for your business? In this article, we provide an invoice finance definition and explain how it can help you improve your working capital and safeguard your cash flow.

Invoice financing is a form of short-term borrowing in which your business borrows money against the amount due on invoices you’ve issued to your customers. These trade receivables are then used as collateral.

Invoice financing is used regularly in a wide range of sectors and industries, such as construction, retail, transportation, and consumer goods.

If a significant amount of your company’s assets is locked up in receivables, and if those receivables make up a very high percentage of your current assets (perhaps because of overly lengthy payment terms), invoice financing could help you avoid working capital issues. This can make invoice financing for small businesses an attractive option. 

To complement the invoice finance definition, know that invoice financing is sometimes referred to as " accounts receivable financing", "receivables financing", or "invoice discounting". But it is not exactly the same thing as "invoice factoring".

Invoice factoring is an agreement with a third-party company (the “factor”) to purchase your accounts receivables at a reduced amount of the face value of the invoices (typically 70% to 90% of the total).

Unlike with invoice financing, these contracts often offer to handle invoicing and debt collection on your behalf. Invoice factoring can minimise your credit risk as it doesn’t require you to put up collateral, but it does mean you effectively lose control of your client relationship since it is the factor – not you – that will collect the money from your customer.

Here is a step-by-step of how invoice financing work:

1. You provide the goods/services for your customers and immediately invoice them.
2. You send those invoice details to the invoice financing provider (the lender).
3. You receive a percentage of the face value of the invoice, usually within 48 hours (the percentage depends upon the lender’s own risk criteria).
4. You collect payment from your customers as usual.
5. When your customers pay you, you settle your account: reimbursing the lender and retaining the portion of the invoice that wasn’t part of your invoice financing agreement – less a service fee.

Yes, there are costs involved in invoice financing.

The lender will charge interest on the amount you borrow, as well as fees (generally a percentage of the invoice totals). Taken together, this can represent a total of up to 30% of the value of your invoices in annual interest.

In addition, as mentioned above, you are responsible for collecting the invoices due from your customer and must reimburse the lender for the amount borrowed. 

To understand invoice finance comprehensively, it’s crucial to consider the lender's perspective as well.​

When a business opts for invoice financing, it not only gains immediate liquidity but also transfers a portion of its credit risk to the lender. Lenders view invoices as collateral, which provides a security layer not present in unsecured lines of credit.​

This structure is beneficial for lenders as it limits their risk exposure, ensuring that they are not left without recourse should the borrower fail to meet its obligations. However, it’s important for businesses to recognize that this arrangement can also affect their relationships with customers, especially if the invoicing is managed by the lender.​

Invoice financing lenders consider several factors in making their decision to accept your company as a borrower.

For example:

1. The amount of invoice financing required for the business.
2. The financial turnover of your company so far.
3. The customer base of your business (the more varied, the better).
4. The total outstanding amount of your outstanding invoices.
5. The visibility of your business.

These considerations also apply to SME invoice financing.

Two factors make invoice SME invoice financing attractive to small and medium businesses:

1. The withdrawal of government financial support offered to these businesses during the Covid-19 pandemic.
2. Changes in banking regulations being implemented in Basel III and Basel IV will increase funding costs and make banks less willing to extend loans, particularly to SMEs with below-average creditworthiness.

SME invoice financing is one of the non-banking funding sources which are filling the need for capital for smaller businesses or new businesses without a long track record. Lenders in this market accept invoice financing applications from newly set up small businesses and will consider the current sales volume and its growth potential as significant factors for approving financing.

It’s important to remember the meaning of invoice financing: even though it can be thought of as cash in advance, it is still a type of borrowing. You want to avoid being overleveraged.

Other disadvantages include:

• Expense: these contracts are expensive in terms of fees (1 to 4%) and only cover a portion of the invoice.
• Limited protection: it may not protect against non-payment (unlike trade credit insurance, which protects you against late and non-payment).
• Non-payment risk: you still face the risk that your customer may be unable to settle the invoice on time, which exposes you to potential financial penalties for your own delayed payments or having to cover the full amount of invoice financing yourself.
• Limited financing: you cannot finance the same invoice multiple times. Because invoices act as a kind of collateral, most lenders will limit you to only one financing per invoice.

While invoice financing is one way to avoid cash flow issues, trade credit insurance remains the most reliable way to deal with trade credit risk and avoid cash flow issues.

Trade credit insurance helps you assess the creditworthiness of your customers and therefore help you decide which ones you can safely do business with, without being limited to only one transaction.

The trade credit insurer defines a credit limit for each customer corresponding to the maximum recommended trading amount. You are covered for this amount and receive compensation quickly in the event of a bad debt.

A trade credit insurance policy also gives peace of mind to your finance partners. Your bankers and other lenders (including those providing invoice financing!) can be reassured about the financial stability of your company, and more inclined to guarantee financing.

All this supports your working capital ratio, lifts uncertainty regarding your cash flow, and secures your company’s ability to grow.

As a global leader in trade credit insurance, Allianz Trade provides world-class knowledge and data to empower your trading decisions. We offer extensive economic and business risk resources thanks to our teams of experts around the world.