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Invoice Financing: Guide for Small Construction Businesses
15 Apr 2021
A lot of businesses often experience a cash flow gap because of unpaid customer invoices. With most of their capital tied up on the accounts receivables, it can be harder for them to maintain smooth business operations. With that, business owners have to find a way to free up their capital and invest it back into their business.
One of the most common solutions that entrepreneurs often turn to is invoice financing. With one, they can get the funds they need by either selling their invoices or using them as collateral. If you’re considering invoice financing, here’s a quick guide to help you get started with your application.
What is Invoice Financing?
Invoice financing is a type of asset-based financing wherein business owners use outstanding invoices for advanced funding. In most cases, the financing company can fund up to 95% of the invoices’ total value. The remaining 5% (minus the invoice factoring fees) will be given back to you once the customers settle their payments.
One main advantage of invoice financing is that it’s easy to qualify for. It’s the reason why businesses, especially start-ups, apply for it in the first place. Unlike other financing types like asset protection trust wherein you have to pledge other business assets, the company’s outstanding invoice will serve as the collateral for the invoice financing. Most of the time, the financing company will base the approval and funding amount on the creditworthiness of the business’ clients. This means that even with bad credit, a business company could still qualify for invoice financing.
Invoice financing is also otherwise known as accounts receivable (A/R) financing.
How Does Invoice Financing Work?
The process of invoice or A/R financing is relatively straightforward. Instead of waiting for weeks to months for your customers to pay their invoices, invoice financing companies can provide you with the cash tied up on the accounts receivables.
With immediate access to cash, you can meet day-to-day expenses and pursue business opportunities. It’s a sure-fire way to invest in your company and expedite its growth.
Here’s a step-by-step breakdown of how invoice financing works:
1. The business generates an invoice for its clients
The process starts with the customer placing an order or books a service from the company. Once the store delivers everything, they then create an invoice and send it over to the clients.
2. Business owners apply for invoice financing
Upon seeing that they need a boost in cash flow since most of their capital is tied up on the outstanding invoices, the business decides to apply for invoice financing.
3. Invoice financing evaluates the application
The business offers its invoices to the financing company and submits the financial and credit documents needed for evaluation. Before approving the financing, most of the financing companies will perform their due diligence. Typically, they’ll do a background check on your customers and base the approval from there.
4. Funding approval
Approval for invoice financing is much faster than other types of financing. Once approved, businesses can expect the funds wired to their accounts within 24 hours. Depending on the result of the due diligence the financing company was able to gather, businesses can get between 60% to 95% of the total value of the invoices.
5. Customers settle their balance
Towards the end of the payment terms, customers will have to pay their invoices. Depending on the terms of the invoice financing, either the financing company or the business owners can collect the payments. However, most businesses usually make use of the former because of the convenience it offers.
6. The financing company gets paid
After the invoices have been paid off, it’s time to pay the financing company. If the financing company handled payment collections, they would simply deduct the advanced cash plus the fees associated with the service. They will then transfer the remaining balance back to the business.
4 Main Types of Invoice Financing
Invoice financing comes in four different types. Each invoice financing type is structured differently from the other. However, the main idea of the financing remains. Companies will still leverage their invoices for funding.
Here are the four types of invoice financing and how they work:
1. Invoice Factoring
Invoice factoring is one of the most common types of invoice financing commonly offered by financing institutions. In invoice financing, the business “sells” its invoices to a third-party factoring company. With that, they will be giving up their control of the ledgers.
Invoice factoring comes in two forms: recourse and non-recourse factoring. The main difference between the two lies in which party assumes most of the risk in the financing arrangement.
- In recourse factoring, the business owners would be responsible for the invoices in case of non-payment. This means that the company would have to pay the unpaid invoices themselves if their client defaults. Another alternative would be to replace the unpaid invoices with invoices of the same value. In recourse financing, most of the risk associated with the funding falls on the business.
- Non-recourse. A not-so-common invoice factoring option, called non-recourse factoring, puts much of the risk on the factoring company’s side. This means that if there are unpaid invoices, the factoring company will shoulder the losses. Companies that have established relationships with creditworthy customers are more likely to qualify for non-recourse factoring.
It’s also worth noting that in invoice factoring, the factoring company will handle the payment collection. With that, the customers will know that the company is working with a factoring company.
2. Invoice Discounting
An alternative to invoice factoring, invoice financing, doesn’t require businesses to give up full control of the ledgers. In this case, the accounts receivables will serve as the collateral for the advanced cash. The company will be responsible for payment chasing and collection. This makes it a perfect financing solution for businesses that prioritizes privacy.
3. Selective Invoice Factoring
Both invoice factoring and discounting require the business to submit its entire sales ledger to the financing company. Selective invoice factoring, however, gives companies more control over which invoices they can use for financing. Businesses usually benefit more from selling a large customer invoice than financing a smaller one. With selective invoice financing, the owners can choose to finance these large invoices and retain control on the invoices with a lesser value.
4. Spot Factoring
Spot factoring refers to a type of invoice financing wherein the business sells a single large invoice (usually amounting to hundreds of thousands of dollars) to the factoring company. Both business and financing companies usually treat this type of financing as a one-time business deal without repeat business expectations.
Spot factoring is a viable option for companies that occasionally find themselves in a cash crunch because of a large unpaid invoice.
Is Invoice Financing Right for Your Construction Business?
At the end of the day, invoice financing could be a valuable financial resource to your company. If you’re experiencing cash flow gaps or need an additional boost on capital to pursue a business opportunity, you can leverage your invoices to get the cash you need. However, since repayments will heavily rely on your customers’ ability to pay the invoices, you would have to make sure that you’re working with reliable and creditworthy clients.
If you’re a construction business occasionally experiencing cash flow issues because of aging outstanding invoices, invoice financing is the easiest way to get paid faster. Keep the information provided above in mind when you’re applying for one. This will help you make informed decisions and maximize the benefits the financing option offers so that you can take your business to another level of success.
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