Invoice finance vs a business loan: which fits your cash flow?

Plenty of profitable businesses run short of cash. You've done the work, sent the invoice, and now you're waiting weeks for the money while wages, suppliers and VAT need paying today. That gap between invoicing and getting paid is where invoice finance and business loans compete.

They work very differently. A loan gives you a fixed sum and a fixed repayment plan. Invoice finance turns your unpaid invoices into cash as you raise them, and the amount you can draw rises and falls with your sales. This guide explains both, what they cost, and how to tell which one fits.

How invoice finance works

Invoice finance lets you borrow against invoices you've issued to business customers. The provider advances most of an invoice's value, often within a day or two of you raising it. When your customer pays, the provider takes back its advance and fees, and passes the rest to you.

Three numbers matter:

• The advance rate. The share of each invoice you receive up front. Providers commonly advance somewhere between 70% and 90%, depending on your customers, your sector and how reliably invoices get paid.
• The service fee. A charge for running the facility, usually a percentage of the invoices you put through it, or a fixed monthly fee. Some facilities also have a minimum annual fee.
• The discount charge. Interest on the money you've actually drawn, for as long as it's outstanding. It's often quoted as a margin over the Bank of England base rate, so it can move.

There are two main types, and the difference is about who chases your customers.

Factoring

With factoring, the provider runs your sales ledger. It sends statements, chases payment and collects the money, so your customers know a finance company is involved. That suits smaller businesses without a dedicated credit controller, because you're effectively outsourcing collections as well as getting funding. The trade-off is cost, since you're paying for a service, and some loss of control over how your customers are treated.

Invoice discounting

With invoice discounting, you keep collecting from your own customers, and the arrangement is usually confidential. Customers pay into a bank account that looks like yours but is controlled by the provider. Because you're doing the credit control, providers normally want to see a business with a solid track record, decent turnover and a well-run sales ledger. It's usually cheaper than factoring for the same amount of funding.

Recourse and non-recourse

Most facilities are with recourse: if a customer doesn't pay within an agreed period, you have to repay the advance on that invoice. Non-recourse facilities include credit protection, so the provider absorbs the loss if an approved customer becomes insolvent. That protection costs extra, and it usually covers insolvency rather than a customer simply disputing the work.

Whole ledger or selective

You'll also choose how much of your sales to finance.

• Whole-ledger (whole turnover) facilities cover all your invoices to business customers. They're typically cheaper per pound borrowed, but often come with a minimum contract term, a notice period and sometimes a fee for leaving early. Read those terms as carefully as the price.
• Selective invoice finance (sometimes called single invoice or spot factoring) lets you finance individual invoices when you need to. There's no long commitment, but each invoice usually costs more, as a percentage, than it would under a whole-ledger facility.

Selective finance suits a business with an occasional big invoice or an irregular cash crunch. Whole-ledger suits a business that's always waiting on customers and wants a steady, growing source of funding.

How a business loan works

A business loan is simpler. You borrow a fixed amount, usually for one to five years for unsecured lending, and repay it in set monthly instalments of capital and interest. You know the total cost from day one, and the money can be used for almost anything.

Loans can be unsecured or secured on property or other assets, and directors of limited companies are usually asked for a personal guarantee. Our guides to secured and unsecured business loans and personal guarantees go into both in detail.

The catch for cash flow is that a loan is a fixed amount. If your sales grow, the loan doesn't. If your gap is only six weeks long, you're still paying interest on the full sum over the whole term, unless you repay early, which some loans charge for.

Side by side

A debenture, mentioned in the table, is a legal charge that gives a lender security over a company's assets. Invoice finance providers commonly take one so they rank first on the invoices. If you already have a bank debenture, the two lenders will usually need to agree who gets what, which can slow things down.

A worked example

An illustration, not a quote. Say you're a contractor who has just invoiced a customer £20,000 on 60-day terms. On a selective facility with an 85% advance, you'd receive £17,000 within a day or two.

Suppose the provider charges a 1% service fee (£200) and a discount charge equivalent to 10% a year on the £17,000 drawn. Over 60 days, that's about £280. Total cost: roughly £480.

When your customer pays the £20,000, the provider keeps its £17,000 and £480 of fees, and releases about £2,520 to you.

Compare a £17,000 loan over 12 months. Even if you only needed the money for two months, you'd pay interest and any arrangement fee across the whole year. On the other hand, if you'll need the same £17,000 permanently, for stock or a new hire, the loan's fixed cost may work out cheaper and simpler than financing invoice after invoice.

Real pricing depends on your customers, your sector, the size of your ledger and the type of facility. The point is to compare the total cost in pounds for the time you actually need the money.

Who each one suits

Invoice finance tends to suit you if:

• You sell to other businesses or the public sector on credit terms
• Your customers are creditworthy but slow
• You're growing, and each new contract widens the gap between paying costs and getting paid
• Your own credit history is thin or patchy, but your customers are solid. Providers lean heavily on the quality of the people who owe you money

A business loan tends to suit you if:

• You need a fixed sum for a specific purpose, such as equipment, a refurbishment or a stock order
• You sell mainly to consumers, so you don't have business invoices to finance. If most of your takings come through a card machine, it's also worth reading how a merchant cash advance works
• You want predictable payments and no change to how your customers are invoiced
• Your need is one-off rather than a recurring gap

Some sectors are harder for invoice finance. Construction work billed through applications for payment and retentions, contracts paid in stages, and ledgers where one customer makes up most of your sales can all limit what's available. Specialist providers exist for most of these, but terms may be tighter.

Common mistakes to avoid

• Comparing headline rates only. An invoice finance quote with a low discount charge can still be expensive once you add the service fee, minimum fees, audit fees and charges for extra services. Ask for an estimate of the total annual cost based on your real turnover.
• Ignoring the exit terms. Whole-ledger contracts often have a minimum period and a notice period. Check what leaving costs before you sign, not when you want to switch.
• Using a loan to fix a recurring gap. If customers always pay late, a loan helps once. Then the gap returns and you're paying off a loan as well.
• Forgetting concentration limits. If one customer makes up a large share of your invoices, the provider may cap how much it will advance against them.
• Assuming confidentiality. Factoring is visible to your customers. If that matters to your relationships, ask whether you qualify for confidential invoice discounting.

Questions people ask

Is invoice finance cheaper than a business loan?

Not necessarily. For a short gap, invoice finance can cost less because you only pay the discount charge while money is drawn. For long-term borrowing, a loan's fixed cost is often lower. Compare the total cost in pounds over the period you actually need the money.

Will my customers know I'm using invoice finance?

With factoring, yes, because the provider collects payment from them. With confidential invoice discounting, you keep collecting and your customers normally won't know. Providers usually reserve confidential facilities for more established businesses.

Can I use invoice finance if I sell to consumers?

Generally no. Invoice finance works against invoices owed by businesses or public bodies on credit terms. If you take card payments from consumers, a merchant cash advance or a business loan is more likely to fit.

What happens if my customer doesn't pay?

On a recourse facility, which is the most common type, you have to repay the advance on that invoice after an agreed period. On a non-recourse facility with credit protection, the provider covers the loss if an approved customer becomes insolvent, but not usually if the customer disputes the work.

Can a new business get invoice finance?

Often, yes. Because providers focus on the quality of your customers, a young business with creditworthy customers and properly documented invoices can qualify sooner than it would for an unsecured loan. Expect more checks and possibly a lower advance rate at first.