What is Invoice Discounting and How Does it Work?

Invoice discounting is a form of alternative finance in which business owners have an agreement to sell their unpaid invoices (accounts receivable) to a third party.

Read on to find out more about how this popular form of alternative finance can help your business.

How Does an Invoice Discounting Facility Work?

A form of working capital finance, invoice finance increases the cash moving through a business.

Using your existing invoices as security for a short term loan, businesses, gain access to most of the the money in advance by leveraging their sales ledger (minus the lender’s fee). This serves to inject the business with much-needed cash flow and improves the Working Capital Cycle (WCC).

Invoice discounting is flexible and adapts to the changes and growth of a business which is why many consider it to be a better fit for their business when compared with more traditional forms of finance such as loans and overdrafts.

What are the Risks?

The lending risk is limited since:

1.  Only a percentage of loans can be discounted, meaning there’s always a safety buffer.
2. The lender knows that the invoice has already been issued so, assuming there’s no history of late payment, it stands a high chance of receiving full payment.

As to the risks to you as a borrower, the chief thing to look out for are buried terms and conditions that may add on hidden fees or charges. Always use a reputable provider and of course scrutinise the fine print carefully.

You also need to manage your business affairs so that you don’t become reliant upon invoice discounting. Ideally it should be used as a short to medium term funding solution.

What’s the Invoice Discounting Process?

Every month, the business borrowing the money sends an accounts receivable report to their invoice discounting provider. This data is then used to adjust the amount of debt they are willing to loan.

The business using the discounting facility remains responsible for issuing and collecting payment of the invoices in the normal fashion with its customers. This is why it is often referred to as discreet, or confidential invoice discounting. 

Advantages

• Invoice discounting accelerates cash-flow, since you don’t have to wait for your customers to pay.
• You do not need to own any high value assets in order to attain funding. This can be hugely beneficial for a lot of businesses in comparison with more traditional business loans, due to banks often requiring assets as leverage before funding is released.
• It’s available to companies who may have been refused traditional bank finance due to poor credit.
• It is usually arranged confidentially which can benefit relationships with customers.
• It can provide more cash than business loans or overdrafts at the bank.
• The facility adapts to your business’ requirements whilst responding to the sales ledger, so it is a flexible finance solution.

What are the Costs?

You should expect interest of 1.5% to 3.0% above bank base rates plus a management fee of between 0.2% and 0.5% of turnover.

You should also check if there are termination costs in the contract or other hidden fees.

What is Invoice Discounting ‘with Recourse’?

This is a common term and condition added to many Invoice Discounting contracts which asserts the lenders right to be paid their fee, even if the customer defaults on their invoice. It means, essentially, that you (your company) remain liable for debts.

Is it Suitable for My Business?

Invoice discounting may be suited to your business if the following applies:

• The business has higher profit margins, as this makes it more able to handle the higher interest rates.
• You are an established business and have effective credit control systems in place.
• You have little or no history of customers disputing invoices, paying them late or bad debts. 
• Your turnover exceeds the minimum threshold from the lender.

For those businesses that do not have adequate credit control processes in place, invoice factoring may be better suited to you.

Some of the common sectors that use invoice discounting include: recruitment, construction, manufacturing, transport or haulage, wholesale and printing.

How Does Confidential Invoice Discounting Work?

Confidential discounting allows you to take advantage of asset based financing without having to alert your customers. Usually coming at a slightly higher premium, and not able to every customer, confidential discounting negates any concerns that customers may worry about your financial stability.

What is the Difference between Invoice Discounting and Factoring?

The basic difference is that with factoring the provider (lender) takes control of the sale ledger, collecting invoices and chasing any late payments.

Discounting is the better option for businesses who want to retain control of their invoice book, and collecting their own payments. There’s no need to alert your clients that a finance arrangement is in place.

We cover the subject of invoice factoring Vs. discounting here in a full article.

Is Invoice Discounting Regulated by the FCA?

Neither Invoice discounting, or any type of invoice finance, is currently regulated by the FCA.

The case for regulation, as it is sometimes raised, often hinges around the notion that the industry is ride with hidden fees and that businesses are somehow being taken advantage of. As brokers within this industry for many years this isn’t our experience, which is not to say that it doesn’t exist, but merely that it’s the exception rather than the rule. As with any financial transaction, it’s up to the individual clients to read all terms and conditions carefully, and of course to work with an established broker such as ourselves who can recommend a reputable and trustworthy provider.