T here are many options for businesses looking to leverage money from future payments for goods and services, but which route is best for you?

Invoice financing is a general term used whenever a third party agrees to buy your unpaid invoices for a fee. Invoice financiers can be a specialist independent company, part of a bank or other financial institution, or one or more individuals (using crowdsourcing platforms, such as Market Invoice or Platform Black).

There are two broad types of invoice financing in the UK – factoring and invoice discounting.

In recent times, there has been considerable growth in invoice trading, which is another form of invoice financing that uses a crowdsourcing approach to access wealthy individuals to provide the finance (instead of financial institutions).

Here, I outline all of these methods and offer the pros and cons of each:

Factoring

This usually involves an invoice financier (such as Bibby Financial Services and Calverton Finance) managing a company’s sales ledger and collecting money owed by customers themselves. This involves 100pc of trade debtors being managed by the factoring company.

A company’s customers will know the business is using invoice finance. When you raise an invoice, the invoice financier will “buy” the debt owed by the customer. The financier makes a percentage of the cost (usually around 85pc) available to the company upfront (usually within 48 hours). The financier then collects the full amount directly from the customer.

Once the money has been received from the customer, the financier makes the remaining balance available to the company, after deducting a “discount charge” (interest) and fees. The amount depends on which invoice financier is used and the creditworthiness of the customer.

Advantages

You outsource sales ledger management, freeing up time to manage your business.

Potential customers are credit checked, so you’re likely to trade with customers that pay on time.

Disadvantages

Your customers may prefer to deal with you directly.

It may affect the image of your company (for example, appearing unable to manage debt collection), or you may have a different culture to the factoring company.

Invoice trading

It's similar to factoring, but invoice trading involves companies “selling” invoices to financiers. The key difference here is that invoice trading uses online platforms as a tool to allow businesses to bypass traditional financiers, and obtain finance from individual investors (or groups of investors) instead. The concept takes the principle of peer-to-peer lending and applies it to invoice finance.

Advantages

It allows companies to pick and choose which invoices it sells (as there’s no need to outsource debt collection for the entire sales ledger, unlike factoring). This would suit a company that has, for example, one customer that demands very different credit terms to the remainder of the sales portfolio. For instance, if a company trades with a powerful customer that may demand 90 days credit terms, the company can use invoice trading to access the cash on this one invoice without doing so for the whole portfolio.

Disadvantages

Like factoring, your customers may prefer to deal with you directly.

Again it may affect customers’ image of the company.

Invoice discounting

With this route, the invoice financier won’t manage the company’s sales ledger or collect debts on the company’s behalf. Instead, the financier lends the company money against unpaid invoices – this is usually an agreed percentage of their total value. The company has to pay a pre-agreed fee for this service. The company is still responsible for collecting debts if it uses invoice discounting, but it can be arranged confidentially so customers won’t be aware.

In many ways, this form of financing is similar to a bank overdraft – the company has access to short-term cash when the company needs it and, for this, the company pays a facility fee.

Advantages

It can be arranged confidentially, so your customers won’t know that you’re borrowing against their invoices.

Disadvantages

The company is still responsible for chasing and collecting the debts from customers.

Other questions to consider

Is any form of invoice financing suitable for your company?

Handing over the responsibility for collecting a trade debt to someone else and/or having certainty over the timing of cash receipts can be very appealing, but as you would expect, this has certain drawbacks and limitations:

Profitability will be reduced. With costs, you will lose profit from orders or services that you provide.

Credit rating may be affected. As this is a form of financing, and there will be fewer unsecured assets available, and it may affect a company’s ability to get other funding.

Invoice financiers typically buy commercial (business to business invoices). If the company is a business to consumer business, you are less likely to find a financier.

So, consider how desperately your business needs the cash. If the business can afford to wait for the cash to be collected from the trade debtor (and self fund), this will almost certainly be a more profitable decision.

Is your need for short-term cash a regular occurrence or a one-off?

The key selling point for invoice trading, compared to the traditional factoring approach, is flexibility. Many factoring companies require businesses to “sell” some, or all of their sales invoices each month. By contrast, invoice financing allows businesses to pick and choose when they use the service.

So, if your business’s cash flow position is unusually low (perhaps due to a one-off purchase of new machinery), then the flexibility provided by invoice financing is very attractive. If, however, you are looking to convert trade debtors into cash quickly on a longer term basis, the auction process format used by invoice financing is unlikely to appeal, as it provides less certainty over the amount of cash your business will receive.

Consider all the financing options available – and look at the costs and risks of each

Invoice financing provides flexibility, but that comes at a cost. Invoice financing can be expensive. So it’s sensible for any business that needs cash in the short term to consider as many finance options as possible to ensure it chooses the one that best meets its requirements.

For example, if the company can foresee that it’s likely to have a cash shortfall in the future, it may consider applying for an approved business bank overdraft. This would provide the required flexibility, provide certain access to cash, and may be a cheaper alternative.

Similarly, the business may wish to consider bank loans, peer-to-peer lending, asset based finance, leasing and hire purchase as feasible alternatives to invoice financing.

James Richardson is a chartered accountant and director at Metric Accountants