Invoice finance is short term finance that involves a business selling their debts to the financier at a lower value than the debt is worth. For example, a business sells a product to a customer for £100. The business will sell this debt to the financier for £85. So, your business is receiving £85 instead of £100.
In essence there are two types of invoice finance agreements, ‘with recourse’ and ‘without recourse’. In ‘with recourse’ agreements the business retains the risk of customers not paying (bad debts) and if this happens the business must repay the bad debt to the financier. In ‘without recourse’ agreements the risk of bad debts passes to the financier, therefore the business will not have to make good any bad debts. Consequently, ‘without recourse’ finance is much more expensive.
Invoice finance does appear to be a bit of a bad deal, so what is the point of it? Consider the example above, the £85 is available immediately whereas the £100 may not be available for some time since the customer may have credit terms of 30 days meaning the cash won’t be received for at least 30 days. There is also the chance the customer may not pay at all therefore the business will never receive the £100. Having the funds immediately assists cash flow and eliminates the risk of non-payment in ‘without recourse’ agreements.
So how does invoice finance work in practice?
The financier will give the business a new account with a pre-determined drawdown limit. As the business issues sales invoices to customer’s the amount of drawdown from the new account will increase, although there will be a maximum, which will vary from agreement to agreement. The business will transfer the cash to a current account, i.e. draw it down, hence putting the finance invoice account in to an overdrawn position.
When the business customers pay their debts the cash is banked in the invoice finance account to reduce the overdrawn balance.
The invoice finance company will charge the business for the privilege and there will be interest and fees charged to the invoice finance account on a monthly basis, which must be repaid by the business.
The administration involved in maintaining the invoice finance account is a burden and can become mindboggling. The invoice finance company will require sales invoice lists, aged debtor reports, details of bad debts etc on a regular basis and the provision of this information will be built in to the finance invoice agreement.
In some circumstances the invoice finance company may take over the business’ sales ledger function, which results in a loss of control which is not a good thing given the importance of the sales ledger function. This may also have an adverse effect on sales as many customers do not like dealing with invoice finance customers.
Before deciding to embark on invoice finance it is important to weigh up the advantages and disadvantages since no matter how the financiers’ dress it up invoice finance is a very expensive form of finance, therefore it is recommended a business seeks alternative forms of finance in the first instance. If there are no alternatives and invoice finance has to be used during periods of negative cash flow it should be used for the shortest time only and other forms of finance should be taken out as soon as practically possible.
Written by yackers1
ACCA qualified accountant who thirives in the world of business and finance
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