Invoice Financing: What It Is and How It Works

Lauren WardUpdated April 19, 2023

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Invoice financing allows businesses to improve their cash flow while they’re waiting for their customers to make outstanding payments. But like any type of financial product, invoice financing comes with both positives and negatives. Find out how invoice financing works, what types of businesses it’s suited for, and alternatives you might want to consider before making a decision about what kind of financing is best for your business.

What Is Invoice Financing?

Invoicing financing is a type of short-term business loan based on the outstanding invoices you have from your customers. Also called accounts receivable financing, invoice financing is considered to be secured funding because your company invoices serve as collateral for the funds you receive. In addition to this traditional secured loan structure, there are several other kinds of invoice financing. One of these is invoice factoring, in which you actually sell your unpaid invoices to a factoring company for a percentage of the invoices’ face value. The factoring company then becomes responsible for collecting from your customers. Another form of invoice financing is what’s called an accounts receivable line of credit. In this kind of financing, you can take out a line of credit using some percentage of the value of your unpaid invoices as collateral. While it’s not designed for all types of businesses, invoice financing can help many companies with longer billing cycles.

How Does Invoice Financing Work?

Invoicing financing primarily benefits B2B companies rather than B2C companies. It’s not made for businesses that rely on individual customers who buy products through a point-of-sale system. Instead, it’s designed to let companies borrow against outstanding invoices for customer orders. When you’re trying to qualify for invoice financing, a lender typically reviews your business credit and the documentation you have demonstrating your unpaid invoices. A lender may also look at your clients’ payment history to gauge how likely they are to pay the invoices. A personal guarantee isn’t usually required, but check the terms of your loan just to make sure.Some lenders allow you to finance 100% of the invoice amount, while others limit you to borrowing up to a certain percentage of your outstanding invoices. The fee structure varies depending on your loan agreement. You may either pay a flat-rate fee or a percentage of the invoice amount. Either way, the fee is deducted when the customer pays the invoice. (Be warned, however, that if your customers are slow to pay, the fees you’re charged may increase, and if they default, you may end up having to cover their invoices.)You may also encounter other kinds of fees with invoice financing, depending on the lender. There may be new account and renewal fees, a minimum volume fee, and/or an early termination fee if you decide to stop using the service. It’s always a good idea to check out the full cost of financing before you sign a contract.

Invoice Financing Vs. Invoice Factoring

Invoice financing and invoice factoring are terms that are easy to confuse. While you might even see them used interchangeably, they aren’t the same thing. Invoice factoring is a kind of invoice financing, but it’s not actually a loan. Instead, invoice factoring is a type of cash advance based on your outstanding invoices. You typically give the invoices to a factoring company and receive an advance of up to 80% of the invoices’ amount. Once the customer pays the invoice to the factoring company, you’ll receive the remaining balance minus a factoring fee that is withheld by the factoring company. Instead of being charged an interest rate, you’re charged a factor rate that’s based on the risk of your invoices. Invoice factoring usually shifts the collection process over to the lender. With invoice financing, your business typically keeps control of customer relations and the collection of your invoice funds. If you opt for factoring, your customers will likely know that you’ve outsourced this part of your business. Some businesses may prefer to keep the collection process in-house to maintain their customer relationships.Both invoice financing and invoice factoring involve ongoing fees. Typically, the longer each invoice goes unpaid, the more you’ll be charged. That kind of tiered rate adds some uncertainty to how much you’ll actually owe.Recommended: What Is the Typical Interest Rate on a Small Business Loan?

Example of How Invoice Factoring Works

Invoice financing can be tricky because it often uses a factor rate rather than an interest rate to calculate how much you owe. A factor rate may have a short term — like a week — which means that even if the percentage you see is low, your obligations will build quickly.Let’s say you have a small business with an outstanding invoice for $20,000. If you were to get a weekly factoring rate of 1%, at day 30 the factoring fee would be $450, and at day 60 it would be $850.By way of contrast, if you chose a monthly factoring rate of 1.5%, you’d owe $300 at day 30. But of course, clearly you’re best off if the client pays the invoice promptly.

Pros and Cons of Invoice Financing

Invoicing financing can potentially help your business in a number of ways, but it also has its drawbacks.

Pros of Invoice Financing

Fast cash always sounds appealing. But specifically, invoice financing comes with the following advantages.

Improves cash flow
Provides businesses with a working capital boost during slow periods
Allows continuity for businesses with long billing cycles who don’t want to operate order to order
Easy application (usually a credit check and invoice documentation)
Fast access to funds, sometimes within a day of application

Cons of Invoice Financing

There are, of course, some downsides to consider as well.

Can be expensive, with potentially high rates plus other fees
Deprives you of a portion of your revenue
Your fees are in part based on whether others (your customers) are making payments on time
If you use a factoring agency, it will probably be interacting with your clients and could affect your relationship with them

Is Invoice Financing a Good Idea?

Invoice financing can be a useful financial tool in some cases. If your company has seasonal fluctuations, a lengthy billing cycle, or revenues that aren’t distributed throughout the year, but also has clients who reliably pay their invoices in a timely way, invoice financing may be a good way to keep a regular cash flow through the highs and lows. If your business has less reliable clients, using funding like this could end up costing you in the long run.

Alternatives to Invoice Financing

Invoice financing is far from the only type of financing out there. Here are a few other small business loan options to consider before you make a decision. Inventory financing: You can apply for either a loan or line of credit with inventory financing. The amount you can borrow is based on the value of your business’s inventory, but typically you can only qualify for between 20% and 65%. Lenders may also use liquidation value as a starting point, since some types of inventory can lose value over time.Inventory financing is used to help businesses purchase new inventory in large quantities and can be useful before a busy season or when you experience sudden demand for your product.Like invoice financing, inventory financing typically comes with higher costs than a regular business loan. You’ll also need to demonstrate a high inventory turnover rate to qualify for higher loan amounts. Merchant cash advance: A merchant cash advance is better suited to businesses with B2C sales. You borrow a lump sum and then the lender automatically deducts a portion of your credit and debit card sales until the loan (plus accrued fees) is repaid. As with invoice factoring, a factor rate is used with a merchant cash advance instead of an interest rate. Another similarity is that your number of sales, rather than your credit history, is the most important factor in qualifying for a merchant cash advance. Generally, approval also happens pretty quickly, allowing you to get fast access to funding. Long-term business loan: A long-term business loan typically lasts between a few years and as long as 25 years. Rather than bridging cash flow gaps, this type of financing is usually used for larger investments, such as buying real estate, renovating a building, purchasing equipment, or acquiring another business. Expect eligibility requirements to be stricter with a long-term business loan. Lenders may require you to have been in business for a minimum amount of time and have strong business and personal credit history. Additionally, you may need to offer some collateral and meet a revenue threshold.

The Takeaway

Cash flow can be an issue for many small businesses. If your business is a good candidate for invoice financing and you need cash, this type of funding may be able to help tide you over.Whether you’re looking for a short- or long-term financing solution, finding the best type of loan for your business can take time and consideration. You’ll want to carefully weigh the pros, cons, and costs of each option to make sure it best suits the needs of your company. If you’re curious about what types of business financing you may be eligible for, Lantern by Sofi can help. With our online lending tool, you can receive an offers from a top small business lender matched to your needs and qualifications. There’s no need to scour the web or fill out multiple applications.Ready to explore your small business financing options? Get started by filling out a simple form with a few details about your company.

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About the Author

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.

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