What is invoice discounting?
Types of invoice discounting
Whole turnover invoice discounting
Whole turnover invoice discounting is the practice of selling an entire sales ledger (all of your invoices) to the invoice discounting company. This is most suitable for you if your business operates through long-term contracts, providing long-term services, or distributing products wholesale.
Selective invoice discounting
Selective invoice discounting (also known as spot financing) is when a business sells individual invoices on an as-needed basis. This option is suitable for small businesses as it provides maximum flexibility. Selective invoice discounting is more suitable for you if your business has fluctuating financing needs e.g. you have project-based work or deal in seasonal goods.
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How does invoice discounting work?
Invoice discounting works in 4 simple steps:
Sell goods & services: You sell your goods and services to customers and generate invoices as usual.
Invoice discounting agreement: You agree with the discounting firm that verifies your unpaid invoices.
You get the money: The discounting firm lends up to 90% of the invoice value upfront at a discounted rate. You can use this money to fuel business growth.
Payment collection: In invoice discounting, the business collects invoice payments from the customers and bears responsibility in case of non-payment.
The invoice discounting company typically charges a fee ranging from 1% to 3% to account for the interest, risk, and costs associated with lending the money. Optionally, you can set up a trust account with the invoice discounting company, allowing for direct repayment as soon as your customers pay their invoices.
A lot of lenders prefer this method, as it greatly reduces the risk of nonpayment and helps keep the process confidential.
Advantages of invoice discounting
Invoice discounting offers the following key advantages for businesses:
Advance funding
It provides immediate access to funds, eliminating the wait for customer payments. This improved cash flow is particularly beneficial for small, growing businesses that need to manage their finances without the commitments of traditional loans, especially when dealing with slow-paying clients.
Affordability and simplicity
Invoice discounting is often more cost-effective, quicker, and easier than securing bank loans or capital funding. The approval process is generally more straightforward, making it a viable option for many businesses. It’s advisable to compare various invoice discounting firms for their fees and client testimonials.
Confidentiality
The process is discreet, with customer invoicing and payments proceeding as usual. This approach maintains the confidentiality of the financial arrangements, with the business retaining the responsibility for collecting payments.
Improved customer relationship
With invoice financing, customer interactions remain direct and unchanged. Customers continue to make payments to the business without knowing about the financing agreement. This helps preserve a stable and positive image of the business, avoiding any impression of financial instability or mismanagement.
Disadvantages of invoice discounting
There are some points you need to keep in mind when choosing invoice discounting:
Smaller companies may struggle to obtain invoice discounting
Invoice discounting is generally more accessible to businesses with substantial turnovers. Smaller businesses may find it challenging to secure lenders willing to accept them.
Higher costs
While it provides quick access to funds, invoice discounting can be more expensive than traditional bank loans or other financing options like invoice factoring.
Risk of debt dependency
Relying too heavily on invoice discounting can create debt dependency, potentially affecting the company’s financial stability if the arrangement changes or becomes unavailable.
Differences between invoice discounting and invoice factoring
| Invoice Discounting | Invoice Factoring |
|---|---|
|
A business borrows money against its unpaid invoices from a third party without selling the invoices. |
A business sells its invoices to a third party for immediate cash flow. |
|
The responsibility to collect payments for the invoices remains with the business. |
The factoring company takes responsibility for collecting and managing payments from customers. |
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