Invoice Finance Explained: How It Works and Who It Suits

In this article

• Invoice finance releases up to 90% of invoice value within 24 hours of raising it
• Factoring: the finance company manages your sales ledger and collects debts
• Discounting: confidential; you manage collections yourself
• Cost: a service charge (% of ledger) plus a discount charge (interest on funds drawn)
• Best suited to B2B businesses with 30+ day payment terms and creditworthy customers

How invoice finance works

When you raise an invoice to a commercial customer, you upload it to your invoice finance provider. They advance you up to 90% of the gross invoice value, typically within 24 hours. The remaining 10% (minus fees) is released when your customer pays. The facility is revolving: as invoices are paid and new ones raised, you maintain a continuous working capital facility secured against your debtor book.

The finance company takes a charge over your debtor book as security. They will credit-check your customers before approving invoices for finance, and they will not advance against invoices to customers with poor payment records or insolvency risk. The quality and diversity of your customer base directly affects the size and cost of the facility available.

Invoice finance can fund growth in a way that term loans cannot. As your sales grow and your invoice ledger increases, the facility grows with it. You are not limited to a fixed loan amount that was sized when the business was smaller.

Invoice factoring vs invoice discounting

Invoice factoring means the finance company takes over the management of your sales ledger. They send statements to your customers, chase overdue invoices, and collect payment. Your customers will know you are using the facility because they pay into the finance company's account. Factoring is typically suited to smaller businesses or those without a strong internal credit control function.

Invoice discounting is a confidential arrangement. You continue to manage your own sales ledger and collect debts from your customers in the normal way. Customers are unaware of the facility because they continue to pay into your own bank account. The finance company's involvement is invisible externally. Discounting typically requires a higher minimum turnover (usually £500,000 or more) and a robust internal credit control process.

There is also selective (or spot) invoice finance, where you choose individual invoices to finance rather than your whole ledger. This suits businesses that only occasionally need to accelerate cash flow from specific invoices, without committing to a whole-ledger facility. Selective finance typically costs more per invoice than a whole-ledger facility but has no ongoing commitment.

The cost of invoice finance

Invoice finance involves two charges. The service charge covers the administration of the facility: credit control (for factoring), ledger management, and bad debt protection if included. Service charges range from 0.5% to 3% of annual turnover, billed monthly as a percentage of the ledger.

The discount charge is the interest on funds you have drawn down. It is calculated daily on the outstanding balance and typically ranges from the Bank of England base rate plus 2% to base rate plus 5%, depending on your profile and the provider. If you draw down funds for 30 days, you pay 30 days of discount charge.

Some facilities include bad debt protection (also called non-recourse factoring), where the finance company takes on the credit risk if a debtor becomes insolvent. This adds to the cost but removes the risk of having to repay advances if a customer goes under. For businesses with concentration risk (one or two customers making up a large proportion of the ledger), bad debt protection is worth considering.

Is invoice finance right for your business?

Invoice finance works well for B2B businesses with: payment terms of 30 days or more, a debtor book of at least £50,000 to £100,000 (for whole-ledger facilities), creditworthy commercial or public-sector customers, and a business model based on delivering goods or services in advance of payment.

It does not work for consumer-facing businesses (the debtors must be commercial entities), businesses with very short payment terms or where customers pay on delivery, or businesses whose customers routinely dispute invoices or return goods. If your customers pay in advance or at the point of sale, you do not have a debtor book to finance.

The key question is whether the cost of the facility is justified by the working capital benefit. A business spending £24,000 per year on invoice finance but unlocking £200,000 of working capital that allows it to take on larger contracts or invest in growth is generating a very strong return on that cost. A business using it to fund overheads it cannot otherwise afford is masking a deeper problem.