Invoice discounting is a financing facility designed to support businesses in maintaining a healthy cash flow. A delay between cash out and cash in can have a considerable knock-on effect on a business’ available working capital, vital for making purchases and investments necessary for growth and development.
This is where invoice discounting as a form of invoice finance can help. In essence it is a form of asset-based finance, where businesses sell their accounts receivable, or invoices, to a third party, and the third party provides most of the value of the invoice upfront in the form of a loan.
It can be helpful to think of invoice discounting as a form of short-term business loan, with your unpaid invoices acting as your security.
Standard and Selective Discounting
There are two types of invoice discounting available: standard invoice discounting and selective invoice discounting, sometimes known as selective invoice finance. Both types involve a business selling their unpaid invoices to a third-party invoice finance company. The third-party then provides the business a percentage of the total invoice funds straight away for a fee. This means the business can receive the funds immediately without having to wait for the client to pay on standard 30, 60 or even 90-day payment terms.
Standard
Standard invoice discounting works as follows:
- The company assigns an invoice to the discounting company with agreed terms and fees.
- Once approved, the lender will receive a copy of the invoice, along with any supporting documents.
- The discounting company advances a percentage of the invoice face value to the business up front, usually 70-90%, minus the agreed charge.
- Once the invoice is settled, you receive the balance due.
Selective
Selective invoice discounting is designed for businesses struggling with unpredictable cash flow at certain times (or due mainly to one or two key clients). It is an effective and affordable solution for many companies, including:
- Companies that make business-to-business (B2B) or business-to-government (B2G) transactions
- Businesses that trade principally with one customer
- Businesses that need a one-off cash flow injection to invest in something new
- Companies experiencing a temporary shortfall in working capital.
- Businesses where key customers have longer payment terms, such as 60- or 90-day deadlines.
Selective discounting is often a better option for established businesses with committed, loyal customers. The risk posed to the finance provider lies with your customers rather than with your business, so many lenders will request evidence that your customers pay consistently, within their deadlines (for this, you must be able to provide a solid track record of customers paying on time).
Most lenders will require one year’s trading history before they consider financing you. With this type of finance, chasing debts is your responsibility, so a lender will want to see that there is a robust debt collections process in place. Lenders prefer financing clients that deal with government agencies or larger, established businesses, who are more credible when it comes to paying invoices.
Which is a better fit for my business?
Invoice-based lending can be a fantastic solution for many businesses. It can be difficult to determine whether invoice discounting or selective invoice discounting is best for you. The primary consideration is whether your company continuously struggles with reconciling outgoings with income, or whether this is only an issue with regards to particular clients or at certain times in the year.
Financing Process
You sell your unpaid invoices to a lender at a discount, usually a percentage of the invoice value. The provider pays you an advance equal to a portion of the invoice’s value, typically 80-95%. Once your clients pay up, you will receive the remaining amount of the invoice from the lender in a second, smaller instalment, minus the lender’s fee. In practice, your business completes work or fulfils orders, you send out the invoice/s to your invoice finance lender. Once they receive the invoice, they deposit the agreed portion of each invoice into your bank account.
You then collect payment from your customers, as usual, using your credit control processes. On the customer side of things, nothing changes. Your business then has this money available straight away to pay bills, repay debt or invest in the company’s growth.
As discussed there are two types of invoice discounting. Selective invoice finance is by and large the same as traditional invoice discounting. The difference with selective invoice finance is generally that clients choose which customers they would like to factor into the facility and which of these customers’ invoices, rather than using the service for their whole sales ledger.
This form of invoice finance affords you more freedom over which invoices are included in the agreement, allowing you to retain more control. You can typically release up to 85% of the value of your invoices with this form of finance. In practice the two forms of invoice discounting work as per below.
Eligibility for a Facility
Invoice discounting is predominantly used by established businesses. More often than not, only companies with a relatively high turnover are eligible. Most lenders require their clients to have a turnover of at least £250,000, some lenders even stipulate a minimum of more than £500,000. On top of this, they will want assurance that your customers will pay, and will pay on time. It is, therefore, only a suitable source of funding for companies with a proven track record and robust credit control processes in place.
Additionally, as the unpaid invoices serve as a form of security for the borrowed money, if your company has already used its accounts receivable as collateral for another finance arrangement, you likely won’t be eligible for invoice discounting.
How Quickly Can I Arrange Invoice Discounting?
Applications for invoice discounting can take several weeks. Some lenders will be able to approve your request within a week. Once an invoice discounting agreement is in place it is a fast way to get access to sizeable amounts of cash. Most lenders will release funds to your business bank account within 24 hours of receiving an invoice.
What if My Credit Rating is Poor?
Invoice discounting is an option for companies who have previously been refused traditional bank finance, owing to poor credit. As the funding is based on sales invoices, the credibility of your customers is more important than your own company’s credit rating.
In essence having or building relationships with credit-worthy customers will help you acquire a lender. What’s more, using this kind of finance can be useful for rebuilding your own businesses credit rating.
Calculating Cost and Recourse
There are two charges involved in invoice discounting. These are the service fee and the discount fee. Be aware, however, that there may be other charges, such as an early termination fee, so be sure to check the small print.
- Service Fee – The service fee represents the annual cost to your business of maintaining the facility. It covers the management and administration of your account and usually represents a percentage of your company turnover, typically 0.25%-2.5%. As your turnover changes, the service fee can change as well.
- Discount Fee – The second cost is the discount fee, which covers the cost of borrowing. It applies to each invoice individually, similarly to the interest on a loan. This fee usually represents 0.5%-3% of the total amount of the invoice for which you receive an advance. This amount can fluctuate depending on how long your customers take to pay their outstanding invoices.
Factors that Affect Fees
How much you pay depends primarily on the level of risk to the lender. A lending company will use several factors to determine their risk level, including:
- The industry in which you trade: some industries carry a higher risk due to inherently long payment terms (in this case factors might want to also see a sufficient level of trade credit insurance in place).
- How many customers you have
- How many invoices you send per month
- Your track record of payment collection
- How robust your payment collection methods are
- With or without recourse.
When it comes specifically to invoice discounting as a form of asset-based lending, lenders will principally assess the price of your fee based on your company’s turnover, your customers and the level of funding you require.
With or Without Recourse
Another significant factor determining how much you must pay is whether you come to an agreement with or without recourse. A clause stating that the deal is with recourse typically means that lenders have the right to their fee and the amount of the invoice already advanced, even if a customer defaults on payment. In other words, your company remains liable if your customers refuse or are unable to pay.
On the other hand, should a lender offer you a discounting agreement without recourse, also known as a non-recourse agreement, this generally indicates that the lender is assuming full liability for customer debt. Non-recourse is also known as Bad Debt Protection and is designed to shield companies from the risks of delayed or unfulfilled payments (effectively a type of business insurance). If your customers are unreliable, this could be a good option for you, as it can remove the pressure of non-paying customers.
Final Thoughts and FAQs
Invoice discounting offers enormous potential for businesses where cash flow problems are an inherent part of their operating model. Invoice discounting can be preferable to other forms of borrowing because it’s based on money coming in in the near future.
By leveraging the value of your sales ledger, you’re unlocking capital that is almost certainly coming back in, which lowers the risk of this type of funding when compared to more traditional types of borrowing.
Whether you’re looking to grow or simply to fill a stop-gap created by one or two problematic customers, invoice discounting can enable you to unlock funds tied up in unpaid invoices without having to wait for the end customer to pay up. This financial flexibility can be of enormous value to your company.
Is Invoice Discounting the Same as Invoice Factoring?
Invoice factoring is another form of invoice finance. It is similar to invoice discounting in that a lender will provide you with a cash advance for invoices owed to you, in return for a fee.
The principle difference is that the provider oversees your credit control. Customers will be aware that you are using an invoice company and will have to pay directly to the third-party, and deal with them in case of any issue.
While this removes some responsibility and work on your part, many customers object to third-party involvement. If you’re going to consider invoice factoring, it’s essential to learn about their collection process to decide whether it could have a damaging effect on customer relations in the event of delayed or non-payment.
Is Invoice Discounting Regulated?
The asset-based finance industry is currently not regulated by the Financial Conduct Authority (FCA) in the UK. The FCA regulates the conduct of thousands of financial services firms in the UK and ensures that all its members fulfil specific standards and adhere to certain rules. Without regulation by the FCA, invoice finance providers are not accountable to particular levels of service.
That said, many asset-based financiers also provide other financial services, for which they must adhere to regulation from the FCA. If the FCA lists your lender for its other financial services, the chances are that it’s a trustworthy finance provider.
Owing to the lack of regulation when it comes to asset-based finance, borrowers must exercise caution when it comes to sourcing a lender. Practise due diligence when comparing finance providers. In particular, ensure that:
- your contract does not exceed 12 months
- all fees are explicitly clear and that there are no hidden charges
- the agreement includes a termination clause
- termination fees don’t exceed two months of service fees.
