Invoice financing vs overdrafts: Which is a better fix for a cash flow deficit?
By Craig Reid, Partner
Late paying customers and cash locked up in unpaid invoices can be frustrating for SMEs, particularly where upcoming payroll and business expenses are around the corner.
As 41.8 per cent of SMEs have experienced late payments, according to an OECD 2024 report, credit facilities can be used to bridge gaps in working capital.
Businesses that need a quick cash injection may consider using invoice financing or an overdraft to meet liabilities.
While these credit facilities serve largely the same purpose, they are each suited to different situations.
What is invoice financing?
Invoice financing works by a lender using unpaid invoices as collateral for funding.
Lenders can advance up to 95 per cent of an invoice’s total value almost immediately, instead of waiting 30 days, 60 days or longer for payment.
The remaining balance of an invoice’s value becomes available when the client pays, but lenders will deduct a service fee and discount depending on the value of loan.
For SMEs that can’t, or don’t want to, borrow more, invoice financing doesn’t add any existing debt.
However, where margins are already narrow, invoice financing can become unaffordable as fee structures can wipe out profitability.
Similarly, a business that operates with a small number of high value invoices may face disproportionately high costs for advancing payments with invoice financing.
In these instances, it could be worth considering a business overdraft.
What are overdrafts?
An overdraft is a pre-arranged credit facility linked to a business bank account, which allows you to spend more than your available balance, up to an agreed limit.
Unlike invoice financing, you will only be charged when a balance turns negative and begin borrowing from the bank, with fees deducted as interest.
Interest rates for UK businesses typically range from the Bank of England base rate plus two to four per cent, up to 15 per cent or more, depending on demand and the lender.
Drawing funds when needed and only getting charged when doing so means overdrafts are relatively straightforward, without any per-invoice admin.
However, banks can reduce or withdraw borrowing limits based on demand, which may leave you short of cash at little notice.
Limits are also set based on your business’s financial health and relationship with the bank.
This means established relationships are likely to receive more favourable borrowing costs and higher credit ceilings.
Which is right for your business?
Both credit facilities can provide the short term cash needed to keep your business running smoothly, but each has different uses and criteria.
Invoice financing could be the better fit if:
- There is a recurring and growing cash flow gap which is caused by late paying customers
- You’ve maxed your overdraft limit or are likely to do so in the future
- You’re finding yourself spending a lot of time chasing payments
- Your business is growing and new contracts are widening the cash flow gap
You may want to consider an overdraft if:
- Your shortfall is occasional and you don’t often have to rely on credit
- You want a borrowing option that only charges when you use it
- You sell directly to consumers or take payments immediately after a sale, so there are no invoices to finance
It is important to consider that each form of borrowing isn’t mutually exclusive, meaning they can be used in tandem.
Invoice financing can cover the predictable gap caused by late paying customers, while an overdraft acts as the stopgap to cover any unforeseen cash emergencies.
An accountant can help you structure your credit facilities, ensuring you have the capacity to meet liabilities without paying unnecessary fees.
Speak to an accountant
Our accountants can model your cash flow to examine whether shortfalls are recurring or occasional.
With this information, we can advise whether an overdraft or invoice financing is the smarter choice for your business.
Where cash flow gaps have been identified, we can help address structural problems and offer other solutions that can help reduce your reliance on borrowing.
Deciding between invoice financing or an overdraft, or both? Contact our experts before approaching a lender.