How does invoice finance work?
Invoice finance is an excellent option for businesses that are growing and are experiencing cash flow issues as a consequence. A simple fact of a normal growing business is that the more you sell, the tighter your cash flow will be, regardless of whether you’re profitable or not.
Invoice financing releases cash tied up in your accounts receivable, enabling your business to continue to grow. As you issue an invoice to a client or customer, your funder pays an agreed percentage of that amount immediately, enabling you to pay your bills and get on with business. The alternative is waiting for the money to come in each month or to use a bank overdraft, which is limited to equity in your property.
There are two types of invoice finance – disclosed and undisclosed or confidential.
With disclosed facilities, the lender may take control of your debtor book and collect the money owed on your behalf. The disadvantage is your clients will be aware someone else is involved, which may put some people off. However, the advantage of disclosed invoice lending is the lender will advance you a higher percentage of the unpaid invoices and perform debt collection for you. For a small business this can be very helpful, ensuring debtors pay when they have agreed to. Also, because the lender is closer to the debtors, they are more comfortable with lending to start ups, young businesses and those that have had troubled trading periods or periods of very low equity.
With an undisclosed or confidential facility, you remain in control of the debt collection. The funder will do an audit of your debtors from time to time to make sure they are comfortable with the level of risk. Generally, undisclosed invoice lending suits more mature businesses with a minimum of 12 months trading. Financiers will be looking for good administrative systems and controls, good paying debtors and quality financial information.
You can finance most trade invoices as long as they’re sound and not aged debts. You are unlikely to be able to finance invoices that are subject to performance standards. This makes debtor financing more difficult in the construction industry, where contracts can have clawback or retention clauses. However, you can always finance just a portion of your invoices – those aligned with a particular contract, for example – or a selection of your debtor ledger.
A key advantage of invoice finance is that the amount of cash you can access will match the size and quality of your debtor book. There is a natural alignment between your access to cash and the cash requirements of your business. Under traditional bank overdraft facilities available to most small to medium businesses, the size of the overdraft limit will be dictated by the value of property-based security available to the bank. And, in many cases, businesses that are fast growing or that have limited property security available will find that their working capital needs will outgrow what traditional banks will offer in terms of overdrafts secured by property.
For more information on how invoice financing could help your business grow, talk to Finance New Zealand.