What Is Invoice Financing? Definition, Structure, and Benefits

What is Invoice Financing?

Invoice financing lets businesses access cash by using their unpaid invoices. Companies use it to improve their cash flow, pay suppliers or employees, and fund growth. It typically comes in forms like factoring and discounting, each with its own benefits and drawbacks. Invoice factoring is helpful for businesses with slow-paying customers, and there are alternative financing methods that can also support cash flow needs.

How Invoice Financing Works

Businesses often sell goods or services on credit to large customers like wholesalers or retailers. This means that the customer does not have to pay immediately for the goods that it purchases. The purchasing company is given an invoice that has the total amount due and the bill's due date. However, offering credit to clients ties up funds that a business might otherwise use to invest or grow its operations. To finance slow-paying accounts receivable or to meet short-term liquidity, businesses may opt to finance their invoices.

Invoice factoring lets a company sell its receivables to boost working capital, giving immediate funds for expenses. Invoice financing is short-term borrowing extended by a lender using unpaid invoices as a basis.

Benefits and Risks of Invoice Financing for Lenders

Invoice financing benefits lenders by using invoices as collateral, unlike unsecured lines of credit, reducing risk if a business doesn't repay. The lender reduces risk by not giving the full invoice amount to the borrowing business. However, invoice financing has risks, like customers possibly not paying their invoices. This would result in a difficult and expensive collections process involving both the bank and the business doing invoice financing with the bank.

Structuring Options for Invoice Financing

Invoice financing can be structured in a number of ways, most commonly via factoring or discounting. With invoice factoring, the company sells its outstanding invoices to a lender, who might pay the company 70% to 85% up front of what the invoices are ultimately worth. Assuming the lender receives full payment for the invoices, it will then remit the remaining 15% to 30% of the invoice amounts to the business, and the business will pay interest and/or fees for the service. Since the lender collects payments from the customers, the customers will be aware of this arrangement, which might reflect poorly on the business.

As an alternative, a business could use invoice discounting, which is similar to invoice factoring except that the business, not the lender, collects payments from customers, so customers are not aware of the arrangement. With invoice discounting, the lender will advance the business up to 95% of the invoice amount. When clients pay their invoices, the business repays the lender, minus a fee or interest.

The Bottom Line

Businesses can use invoice factoring to increase their cash flow by borrowing against unpaid invoices, helping them cover expenses or invest in growth without waiting for customer payments. The two main types are factoring and discounting. Some of the risks involved include customers failing to pay and potential impacts on the company’s reputation. Lenders benefit by using invoices as collateral, reducing their own risk. Businesses should carefully weigh their financial needs, benefits, and risks before choosing invoice financing.