While traditional finance can help you avoid these tricky periods, it’s far more difficult to obtain than it once was. Smaller companies in particular are turning to alternative forms of finance such as invoice finance. Read on for our primer on this controversial form of finance.
What is invoice finance?
Invoice finance involves ‘selling’ invoices (or applications for payment) to a third party in return for an immediate payment of cash based on the value of the invoice. Once the invoice is paid, you receive the remainder of the value of the invoice, minus a fee and interest. This approach allows companies to immediately receive the majority of the value of their invoices in cash, instead of having to wait the 30 or 45 days for the client to pay up. There are two main types of invoice finance: invoice discounting andinvoice factoring. Both types use the process outlined above. However, invoice discounting is confidential – your clients won’t know you’re using invoice finance and it’s still your responsibility to chase payment. Conversely, factoring passes that task over to the financier. They’ll collect payment from your clients directly. Both approaches have advantages and disadvantages. Smaller businesses may prefer to opt for factoring as they may not have the resources to chase payment consistently, whereas large businesses may opt for invoice discounting to maintain client relations and appear more professional.
How does it work in the construction industry?
Invoice financiers are often reluctant to work with construction companies and will offer unfavourable rates. This is because of the increased risk in the industry. Payments are made in stages, and projects may fail at any point in their timelines, ceasing or reducing future payments. Liquidated damage clauses are often present in client-contractor agreements, meaning that the client pays less than the agreed amount if certain requirements aren’t met. Additionally, specialist construction invoice finance products are likely to use uncertified applications for payment instead of invoices. The certified amount may differ significantly from the original figure on the application for payment.
These increased risks means that invoice financiers offer far lower advance rates to construction companies than businesses in other sectors. Instead of expecting an 80-95% advance, construction companies may only be offered between 20% and 60%.
Many invoice finance products may also ignore retentions – they won’t be financed, so you’ll still have to wait the usual amount of time to receive your final payment.
Additionally, don’t underestimate the extra admin burden that factoring requires. You will most likely have to provide your lender with weekly bank statements and regular accounts. Failure to comply with admin rules will lead to higher fees.
Is invoice finance the right choice for our company?
The main advantage of invoice discounting and factoring is clear: obtaining a large chunk of payment weeks or months before you’d usually receive it eliminates your cash flow issues and allows you to start working on your next project right away. However, these arrangements have many downsides that we mentioned above. It’s vital that you have a complete understanding of how your invoice finance agreement works when you sign it.
If you’re concerned about the risks involved in invoice finance, read some more of our tips for tackling cash flow and payment problems in a small construction business.
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