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.
Businesses, therefore, gain access to all the money in advance by leveraging their sales ledger (minus the lender’s fee), thereby injecting their business with much-needed cash flow. It’s an increasingly popular means of improving 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.
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How Can It Help Your Business?
Another way of understanding invoice discounting would be a series of ongoing short-term business loans where invoices are used as security. The lending risk is limited since:
- Only a percentage of loans can be discounted, meaning there’s always a safety buffer.
- 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.
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.
- 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.
Disclosed Vs. Confidential Invoice Finance
For a lender to allow a company to borrow money confidentially, their turnover must be significant, since this is a form of security for the lender. Where companies don’t meet the turnover requirements but still wish to utilise invoice discounting, however, a ‘disclosed’ option is sometimes offered. In this scenario, invoices are submitted with a notice of them indicating that the “invoice has been assigned to an invoice finance provider”.
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.