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.
In other words, you can borrow the money owed to you from clients before they pay up. This form of finance allows you to access cash tied up in unpaid invoices immediately, which minimises the damage of late payment. It is a useful source of funding for businesses who can’t afford to grow or develop when clients are slow to pay their invoices, or for companies that have seasonal fluctuations in cash flow. This guide will take you through the following key sections:
- What is invoice discounting?
- How does it work?
- Advantages & disadvantages of invoice discounting
- Is my business eligible for invoice discounting?
- How much does discounting cost?
- Choosing an invoice discounting provider
- Case study
- Final thoughts & FAQs
What is invoice 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.
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.
How does it work?
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.
How does selective invoice finance work?
Selective 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.
How does selective invoice discounting work?
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.
Advantages & disadvantages of invoice discounting
There are countless funding options available for businesses seeking finance of any kind. From business loans and grants to debt finance and asset-based lending, it can be hard to choose a type of funding or finance that’s best for you.
Research all your options carefully and consider seeking the advice of a financial adviser for more bespoke information. To get you started on analysing if invoice discounting is the right finance sources for your business, the below sections runs through the primary advantages and disadvantages of using invoice.
A significant benefit to invoice discounting as a source of finance is that it can be entirely confidential, which is why this form of borrowing is sometimes known as confidential invoice discounting. In other words, your customers will not know that you are using a finance provider, to which they may object. Confidential invoice discounting is favourable as it allows you to retain control over your customer relations and maintain strong client relationships.
With disclosed invoice discounting, on the other hand, your customers will be aware that you are using a third-party finance provider. The invoices will contain a note to explain the fact, and your customers will pay the lender directly.
Regardless of whether you opt for confidential or disclosed invoice finance, it remains your responsibility to communicate with your customers, to chase them for late-payments and deal with any issues. If you’re looking to remove this responsibility, you can consider other methods such as invoice factoring, where the lender assumes this responsibility.
Up to 95% invoice financing
A principal advantage of using invoice discounting is that you can receive more of the invoice value than with other cash flow solutions. Invoice discounting providers usually offer up to 95% in advance payment. Businesses use invoice discounting for ongoing periods, or to cover their entire sales ledger, which means better rates and lower fees, making it usually a far more cost-effective source of funding than other cash flow management options.
Retaining ledger control
Another significant advantage of invoice discounting is that you can retain control over your own sales ledger and relationships with clients. You don’t have to disclose to customers that you’re using a finance provider, which can sometimes affect your customer relations. It is also a quick way to raise money. Some lenders provide finance within as little as 24 hours, making it an effective solution for immediate financial troubles.
Invoice discounting is also a very flexible cash flow management solution. As your business grows, you can extend the cash available in your facility, allowing you to boost your purchasing power continually. Selective invoice discounting, in particular, is a popular option as there are no long-term contracts involved. There’s a one-off fee per invoice, and there are no fees if you choose to leave a selective invoice discounting agreement. It is a far more flexible option as you can pick and choose when you use it, and you get to maintain complete autonomy over your accounts receivable.
Fees can be disproportionate
Fees are charged against the entire turnover of the business. However, most invoice discounters don’t allow companies to secure finance against their whole sales ledger, which can mean the fees are disproportionate when it comes to how much funding is being secured.
Difficult to obtain with a lower turnover
It can also be challenging to obtain invoice discounting for companies with lower turnover. Lenders typically look for businesses with a minimum turnover of £250,000, although some may consider smaller businesses or even startups.
Getting setup can take time
While invoice discounting is one of the quicker methods of securing finance, bear in mind that if you are opting for selective invoice discounting, it can take a while to set up a selective facility, usually several weeks at a minimum. This time can be costly for a company needing operating liquidity now.
Is my business eligible for invoice discounting?
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.
Can I secure invoice discounting 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.
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 type of businesses use invoice discounting?
Invoice discounting is generally useful for profitable businesses that have difficulty reconciling the timing of cash coming in against the money going out.
Below are some examples of invoice discounting put into practice in fields where invoice discounting can prove particularly useful. Businesses in these sectors are typically funded by large clients with extended payment terms, making it challenging to maintain steady, healthy cash flow. If your struggling to decide if invoice discounting is right for your business, below are examples of how businesses in different industries use it.
Juggling incomings and outgoings can be challenging in the construction industry, particularly if you’re at the bottom of the pyramid. Sub-contractors at the end of the chain often experience lengthy delays in receiving payment.
Using asset-based lending companies to receive advanced funds can be helpful for independent contractors and sole-traders, providing them with enough capital to bid for jobs on an equal footing with established businesses. More working capital means you can invest in more materials and get going with other jobs.
Late payment is a common problem within the logistics industry. It’s also an industry which incurs costs throughout the month, from purchasing fuel to keeping up with vehicle maintenance, on top of paying staff and keeping business operations afloat.
Using invoice finance can provide logistic companies with financial security, providing a regular influx of cash throughout the month (this steady income is key to growth within haulage companies, when releasing capital constantly is necessary to maintain or expand their fleet).
The manufacturing industry is another one which requires careful juggling of cash in and cash out. Manufacture is a process of sequential stages, and one late payment can throw the whole process out of whack, delaying the production time and, as a result, the arrival of income in revenue.
Invoice discounting can help to remove the burden of aligning outgoings against income. With the time pressures removed, a manufacturing company can focus on the bigger picture, and use this available cash to expand, accept new orders and grow their enterprise without the pressures of short term cashflow issues.
The recruitment industry is notorious for having disparate cash flow. Business owners typically experience a large gap between paying their staff and receiving payment for their services, and struggle to get customers to pay on time. Company development can seem impossible for executives at recruitment firms experiencing such a significant lag between money out and money in.
Invoice discounting can provide an invaluable stop-gap for recruitment companies. Receiving cash for work done immediately can be a game-changer in this industry, easing the burden of payroll and opening opportunities for taking on more clients.
How much does discounting cost?
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.
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.
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.
Which factors affect the 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.
However, the fees for an agreement without recourse reflect this higher risk for the lender. Finance providers typically charge considerably higher fees and offer a smaller advance in these arrangements, which can be challenging for companies that require immediate access to significant amounts of cash. Additionally, you must carefully check the terms and conditions that come with a non-recourse agreement. In the case of some invoice disputes, the lender won’t assume liability for the debt, even with a non-recourse arrangement in place.
Choosing between non-recourse and recourse invoice discounting is tricky. There are a number of factors to consider, such as the potential savings for the company long-term, weighed against the damage of being liable for a single or multiple unpaid invoice.
Negotiate on discounting fees
When it comes to getting a good deal, there’s always room for negotiation. There are hundreds of lending companies on the market. Even if you don’t fulfil all the eligibility factors considered above, it’s worth reaching out to multiple companies. Not all lenders were born equal, and some will find your business a lower risk than others. Engaging with your potential lenders and pitching your business to them can go a long way in procuring a better deal. If you can convince your lender that your industry, company and customers are low risk, you’ll pay less.
Some lenders will agree to reduce their fees once you have sold them a certain number of invoices, once they can see that you’re credible, and your customers are trustworthy. It’s worth seeking professional advice on securing an asset-based lending contract, to find out what conditions and rates would best suit your business.
Choosing an invoice discounting provider
Invoice finance is increasing in popularity, meaning there’s more competition than ever. Take the time to fully research your options before you settle on a lender. When researching there are several important things to bear in mind:
- Using invoice finance can exclude you from other forms of business finance – before accepting any invoice finance, ensure that it won’t disqualify you from any other financial services you may need
- Check that your lender is a member of the Asset Based Finance Association and UK Finance, industry bodies which ensure their members agree to its codes of practice
- Consider using an invoice finance broker to help you choose an arrangement that works for you.
If your still not sure quite how factoring works, here’s a quick case study. A family-run recruitment company based in the midlands is looking to expand. The company provide temporary and permanent staff to fulfil a range of positions in the Derbyshire area, including positions in local councils and well-known charities. The firm has seen tremendous growth in the last year, owing to its excellent customer service. However, this growth has come with substantial financial pressure, as the owners struggle to reconcile their cash flow.
The company has a turnover of £500,000, which they expect to double over the next three years. To achieve this impressive growth, they require help to remedy the lag they are experiencing between their deadlines to pay staff and their income from clients.
The company has loyal clients who tend to pay on time. That said, many have payment terms of up to 90 days, which is difficult to reconcile with mounting payroll pressure in busy periods. The business approached an invoice finance broker to discuss their cash flow trouble.
The broker recommended that the company opt for invoice-based borrowing. They found the business an invoice discounting finance solution with a lender offering a 90% advance rate for the invoices. The broker negotiated a facility for £350,000, covering the firm’s entire sales ledger. Using this facility to support ongoing investments, the business expects to triple its turnover within three years, demonstrating how invoice discounting can enable company growth.
Final thoughts & 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.