Invoice finance: how factoring and invoice discounting work

Invoice finance is funding where a provider uses your unpaid invoices to give you a percentage of their value before your customers pay. You raise an invoice, the provider pays you part of it, and you receive the balance, less the provider’s charges, once the customer settles.

It is a mainstream form of business funding. UK Finance, the trade body, says that by the end of 2024 invoice finance and asset-based lending supported 34,000 UK businesses, and that its members are advancing over £21bn to those businesses at any point in time. It is one of the funding types covered in our business finance guides.

The facility follows your sales. As you invoice more, more funding becomes available, and as invoices are paid the balance falls. That is the main difference from a loan, which is a fixed sum repaid on a schedule.

You invoice your customer as normal, the provider pays you part of the invoice, and the rest follows when the customer pays. A typical facility runs like this:

1. You deliver the goods or the service and raise an invoice to your business customer.
2. You send the invoice details to the provider, often through a link to your accounting software.
3. The provider pays you an agreed percentage of the invoice value. The percentage is set in your agreement and depends on the lender, your sector and your customers.
4. Your customer pays the invoice. With factoring the provider collects the payment. With invoice discounting you collect it yourself.
5. The provider pays you the remaining balance, less its charges.

Legally, UK Finance says a provider would normally purchase the right to payment of the debts owed to you, and not simply take security against them. In practice that means the provider has a direct interest in each invoice being valid, undisputed and paid.

The two main types are factoring and invoice discounting, and the difference is who runs credit control. UK Finance describes invoice discounting as the most significant product in the UK, both by the volume of funding and by the number of businesses using it.

You will also hear the terms recourse and non-recourse. As a general explanation, under a recourse facility you carry the loss if a customer does not pay, and the provider can take back what it advanced on that invoice. A non-recourse facility adds bad debt protection, so the provider carries the loss on approved invoices within agreed limits, for an extra charge. The exact meaning sits in each agreement, so read the definition there.

Invoice finance lenders look first at your customers and your invoices, then at your own business. The invoices are what the provider is funding, so their quality matters most. Expect questions about:

• Who your customers are. Providers fund invoices to other businesses, and they assess how likely those customers are to pay.
• How spread out your sales ledger is. A ledger that leans on one or two customers is treated more cautiously.
• Your payment terms and how long customers really take to pay.
• What the invoice is for. Completed work or delivered goods are simpler to fund than stage payments, deposits or work still to be done.
• Disputes and credit notes. A history of queried invoices reduces what a provider will fund.
• Your own accounts, bank statements and credit history, and those of the directors.

Every lender sets its own criteria and any offer is subject to status. A full application may involve a hard credit search.

Invoice finance is priced in several parts, so the cost depends on how much you use the facility as well as on the rates. We do not quote typical rates, because they vary by lender, sector and risk. These are the components to ask about:

• Service fee. A charge for running the facility, commonly linked to the value of invoices you put through it. It is higher where the provider also runs credit control.
• Discount charge. The charge on the money you have drawn, which works like interest on an overdraft.
• Bad debt protection. An extra charge if the facility is non-recourse.
• Set-up and audit fees. Charges for opening the facility and for periodic checks on your sales ledger.
• Minimum fees. A floor on what you pay each month or year, even if you use the facility lightly.
• Exit fees. Charges for ending the agreement before its minimum term or without the full notice period.

Ask each provider for the total expected cost in pounds over a year, at the level of use you realistically expect. Our guide to comparing lenders on total cost explains why the headline rate alone is a poor guide.

The main risks sit in the contract terms, not in the idea of funding invoices. Read these points before you sign:

• Concentration limits. Many facilities cap the share of funding that can rest on one customer. If your largest customer is most of your ledger, you may be funded on less than you expect.
• Minimum fees. If sales dip, or you stop needing the cash, the minimum still applies.
• Contract length and notice. Check the minimum term, the notice period and what leaving early costs.
• Old and disputed invoices. Providers commonly stop funding an invoice once it passes a set age or is disputed, which reduces your availability when you may need it most.
• Security over the company. A provider may also take a charge over the business’s other assets. Our guide to what a debenture means for your company explains how that works.
• Customer relationships. With factoring, a third party speaks to your customers about payment. Ask how the provider handles collections.

On standards, UK Finance runs a Standards Framework that sets and enforces what clients of its invoice finance and asset-based lending members can expect, with an independent complaints process. It is worth asking whether a provider is a member.

Usually not. Under the Business Contract Terms (Assignment of Receivables) Regulations 2018, a contract term has no effect to the extent that it prohibits or restricts the assignment of a receivable arising under that contract. The rule applies to terms in contracts entered into on or after 31 December 2018.

The protection is aimed at smaller suppliers. It does not apply if, at the time of the assignment, the supplier is a large enterprise or a special purpose vehicle, and the regulations list some excluded types of contract. If a large customer’s terms contain a ban on assignment, tell the provider at the start and ask how it treats that customer.

Invoice finance is the right tool when a profitable business is short of cash because customers pay on credit terms. It fits a timing gap in working capital, and it grows with sales. Two common cases:

• A staffing business that pays workers weekly while clients pay monthly or later. See finance for recruitment agencies.
• A manufacturer that buys materials and pays wages long before the finished order is paid for. See funding for manufacturers.

It is the wrong tool in these situations:

• You sell to consumers or are paid at the point of sale. There are no trade invoices to fund.
• The business is losing money. Funding invoices faster does not fix a margin problem.
• You need a one-off sum for a single purpose. A minimum-term facility with minimum fees is an expensive way to borrow once.
• Most of your invoices are disputed, paid in stages or raised before the work is finished.

The main alternatives are a fixed loan, a facility repaid from card sales, an overdraft, and simply collecting faster.

• A fixed sum repaid in instalments: see unsecured business loans. This suits a one-off cost better than a rolling facility.
• If customers pay you by card, not on invoice, a merchant cash advance is repaid as a share of card sales.
• An overdraft or revolving credit facility, if the gap is small and short.
• Tighter credit control: shorter terms, deposits, prompt chasing and statutory interest where a customer pays late.

Capzy is a credit broker, not a lender: we introduce your business to providers whose criteria fit your customers and your sector, and help you compare what comes back. We are paid by the lender. You can check your funding options with a soft search, which does not affect your credit score. A full application to a lender may involve a hard search.

To see who is active in this market, browse the invoice finance lenders in our directory. No lender is obliged to offer a facility, and funding is never guaranteed.