Invoice discounting is a form of business funding that improves cashflow by leveraging unpaid invoices.
Before making any decision as to the right form of financing for a business, it is essential to understand what invoice discounting is and how this process works in practice.
In this guide, we outline the pros and cons of invoice discounting, as well as the potential costs involved and and how this differs to invoice factoring, to help businesses make an informed decision about their funding options.
What is invoice discounting?
Invoice discounting is a popular form of financing for those businesses trading with other businesses on credit terms, typically between 30 to 120 days, in which a provider advances cash to the business up to the value of its unpaid invoices. It is essentially a form of short-term accounts receivable finance, where the business uses its invoices as collateral for a loan, repayable once an invoice is settled, together with a discounting fee.
The term ‘accounts receivable’ refers to the money owed to a business by way of any unpaid invoices, where accounts receivable financing allows a business to recoup early payment on some or all of its outstanding invoices, in return for an invoice discounting fee. In this way, invoice discounting will enable a business to get paid more quickly on its invoices.
As such, invoice discounting represents a popular alternative to more traditional forms of financing, such as short-term bank or bridging loans, not least for any business who does not qualify for a traditional-style loan, perhaps due to a poor credit history, as well as for those businesses looking for a more flexible way to finance any expansion opportunities.
How does invoice discounting work?
For any business working with other businesses on deferred payment terms, even where its invoices are typically paid on time, deferring payment for between 30 to 120 days can put a significant strain on finances. Extending credit terms to customers can also stunt the growth of any business looking to expand, where invoice discounting can be an effective way to both resolve any immediate cashflow problems and to raise working capital.
The discounting provider, also known as the discounter, makes available to the business an agreed percentage of the value of each invoice, to be repaid when the debtor settles the invoice in full, together with the discounter’s fee. However, the business will retain responsibility for chasing and collecting outstanding invoice payments from its customers.
A typical invoice discounting process can be broken down into the following steps:
- The business provides goods or services to its customers in the usual way
- The business invoices its customers for those goods or services, often with deferred payment terms of up to 120 days
- The business provides the raised invoices as proof of what is owed, in this way using the invoice as short-term security for an advance payment from the discounting provider
- The discounting provider evaluates the invoice and agrees to advance a percentage of its value as a short-term loan, often up to 95% of the invoice total
- The customer settles the invoice and the business repays the money advanced to them by the discounter, together with a pre-agreed fee to cover costs, risk and interest.
For example, Joe Blogg’s Business is having cashflow problems and agrees to a discounting facility with Anytime Finance Company based on an immediate advance of 90% of any invoice value. This means that when Joe Blogg’s raises an invoice worth £5,000 and uploads this online, Anytime Finance Company will advance the sum of £4,500. Once the customer has settled the invoice in full, Joe Blogg’s will return the borrowed amount to Anytime Finance Company, together with a pre-agreed fee. In this example, let’s say that Joe Blogg’s Business was liable to pay £250 in fees for the use of the discounting facility, he would need to return a total payment of £4,750 once the invoice had been paid.
In some cases the customer will pay the invoice amount into a trust account in the name of the business but controlled by the lender. In this scenario, once the invoice has been settled in full by the customer, the discounter will pay the business the remaining balance, minus its pre-agreed fee. This reduces the risk of non-payment by the business to the lender yet maintains confidentiality, where the customer appears to be paying the business directly.
By being advanced a significant proportion of an outstanding invoice upfront, rather than having to wait several weeks or months for an invoice to be settled, a business will have far faster access to most of the money owed to it. For a business facing financial difficulties, being able to draw funds in this way can help to discharge a number of different costs, including purchase orders, fuel costs, payroll and taxes. Equally, for those businesses experiencing rapid growth, or looking to expand their existing operations, invoice discounting can provide the ideal working capital solution to meet their financing needs.
As such, invoice discounting can be used to both reduce debt and/or to facilitate the growth of a business. It can also be used on an ongoing basis, releasing funds against some or all of the unpaid invoices of a business for the foreseeable future.
Pros & cons of invoice discounting
In addition to providing a quick and easy solution to any cashflow problems for a business, where the invoice discounting application process is usually much simpler and streamlined than applying for a loan, this form of financing can provide a cost-effective solution for a number of small and medium sized enterprises (SMEs).
Even though the cost of using outstanding invoices as collateral for a loan must be factored in, the fees for invoice discounting are typically far cheaper than the costs usually associated with traditional loans, where SMEs will not be subjected to high-interest repayments. Approval is also based on individual invoices rather than credit history or long-term forecasts, making it more likely that finance companies will approve a facility.
Another key benefit of invoice discounting is the confidential nature of these types of arrangements, where debtors will usually be unaware that the business is borrowing from a third party. This is because the business will be responsible for chasing and processing customer payments, remaining entirely in control of its sales ledger and debtor book.
However, there are also various downsides to discounting arrangements, the most obvious being that the business will usually be liable for any bad debt. This is known as recourse discounting, where if any invoice is not settled in full by a customer, the business will be required to repay the sum advanced to it by the discounting provider. This also means that if any outstanding amount is not paid off, this could potentially affect the credit score of the business and, in turn, its ability to secure alternative finance. Some discounting providers may offer non-recourse discounting, where the discounter agrees to absorb any bad debt. However, there will be significant additional cost for this type of bad debt protection.
How much does invoice discounting cost?
The cost of invoice discounting can vary dramatically depending on the discounter. There are a wide range of providers across the UK offering discounting facilities, including high street banks and large independent providers. However, it is also worth looking at the terms and rates offered by small local invoice discounting providers or niche sector specialists.
An invoice discounting fee will usually comprise several different charges as part of the overall fee structure, including a set-up fee and service fee for the invoice discounting facility, together with interest charges calculated against the balance of funds drawn. This charge will often be applied on a monthly basis and will typically range from between 0.5% to 5% based on various factors, including the overall risk profile of the business and its customers. As such, depending upon the circumstances of the business, the discount rate and the terms of any discounting facility will often be different for different businesses.
The factors to be taken into account by a discounter when deciding on an appropriate rate will include the age and overall turnover of the business; the creditworthiness of its customers, together with the reliability of those customers; the value of invoices to be discounted; the percentage of those invoices to be advanced upfront; and the length of the discounting period, ie; how long customers have to settled an unpaid invoice. In most cases, the lower the risk and the greater the value of invoices, the lower the discounting cost. Conversely, the higher the risk and the lower the value, the higher the cost.
How do invoice discounting and invoice factoring differ?
Both invoice discounting and invoice factoring are forms of invoice finance. This means that they both involve short-term financing against outstanding invoices to help improve the cashflow and working capital of a business. However, there are a number of key differences.
With invoice factoring, the factor ‘buys’ outstanding invoices for slightly less than these are worth, where the discount rate is calculated as a percentage of the total invoice value as payment for advancing the bulk of the cash upfront. The invoice discounter instead ‘loans’ money against the value of unpaid invoices, where these are used as collateral for that loan. The discounter charges a fee for this service, including interest on the funds drawn.
This difference is subtle although, in practical terms, the factor is responsible for collecting and processing outstanding invoice payments, and for the credit control of the business. As direct contact will need to be made between the factor and debtor, and debtors will be required to make payment directly into the factor’s bank account, this arrangement will not usually be confidential. As such, this could potentially impact the working relationship between the business and its customers, where any poor customer service experience with the factor, or customer concerns over financial struggles, may create a bad impression.
In contrast, in an invoice discounting arrangement, the customer will continue to deal with and remit payment to the business directly. As such, customers will not be privy to any discounting arrangement where, for this reason alone, this can represent the better option for those businesses who want to maintain and protect key customer relationships by not drawing attention to their use of a third-party lender or borrowing against their invoices. This type of facility will also not include any cost for sales ledger and collection services, where invoice discounting arrangements are usually far cheaper than factoring facilities.
Still, it can be far easier to secure a factoring facility, whereas invoice discounting is riskier from the perspective of the provider. This is because the discounter does not have any direct involvement in recouping payments or any direct contact with debtors. Due to the higher level of risk involved, most invoice discounters will only lend to established businesses or bigger companies with a healthy turnover of at least £100,000, a positive net worth on their balance sheets and strong in-house credit collection processes. The business must also have creditworthy and reliable customers. This essentially means that invoice factoring is more suited to businesses with a short trading history or low turnover, or facing other challenging circumstances including, for example, the threat of insolvency.
Importantly, it is only by comparing these differences, including the terms and conditions upon which a discounter or factor can provide invoice financing, that an informed decision can be made as to the best short-term finance solution for a business. However, when it comes down to which is the better invoice financing option, where both are readily available to any given business, this will all depend on the size and nature of the business and its needs. The ability of the business to effectively manage sales ledgers, credit control and payment collections, including the time and resources to do so, are also key considerations. For some, a factoring arrangement, where the factor takes responsibility for chasing and processing payments, despite the fact that this may cost more and not be kept confidential from customers, can help to free up valuable time and resources for a business.
Invoice discounting FAQs
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Legal disclaimer
The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal or financial advice, nor is it a complete or authoritative statement of the law or tax rules and should not be treated as such.
Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission.
Before acting on any of the information contained herein, expert professional advice should be sought.
Author
Gill Laing is a qualified Legal Researcher & Analyst with niche specialisms in Law, Tax, Human Resources, Immigration & Employment Law.
Gill is a Multiple Business Owner and the Managing Director of Prof Services Limited - a Marketing & Content Agency for the Professional Services Sector.
