Invoice discounting – an in-depth guide

Invoice discounting means businesses can better manage their cash flow by unlocking the value tied up in unpaid invoices. But is it right for you?

13 December 2019

Cash flow is critical to the success of any business, and invoice discounting is a way to help manage it by getting paid quicker. But how does it work? How much does it cost? And are there any other advantages of using it?

Fear not, this rather handy guide will answer those questions and more. By the end, you should have a much better idea if invoice discounting is right for your business. And even if it’s not, you’ll be able to wow your colleagues with you new-found knowledge of this form of finance.

What is invoice discounting?

Invoice discounting is an opportunity to better manage your business’ cash flow by ‘selling’ your unpaid invoices to a lender.

So, rather than waiting weeks or even months to be paid by your customers, a lender can quickly advance you most of the money owed to you (usually within 24 hours) – for a fee of course.

All of which sounds very promising, especially when you consider 57% of small UK businesses have struggled with cash flow problems. One of the key contributors to this is late payments from customers. With the BACS payment scheme claiming late payments have a direct cost to SMEs of £2 billion. Ouch.

How does invoice discounting work?

In a nutshell, you sell all your unpaid invoices to a lender. In return, they give you a cash advance for a percentage of the invoices’ total amount. Once the invoices have been paid by your customers, you receive the remaining balance, minus the lender’s commission for advancing you the money.

You could also see invoice discounting as a form of short term business loan, where you’re using the unpaid invoices as a form of security. The lender is often happy to advance you the cash, as they can see you’re owed the money from a customer.

How does cash flow work

Disclosed and confidential invoice discounting

Hopefully this next part doesn’t add confusion, but invoice discounting can be done either with or without your customers knowing. When they don’t know it’s called ‘confidential’ and when they do, it’s known as ‘disclosed’.

With confidential invoice discounting, your customers continue to pay you direct. It is then your responsibility to repay what you owe to the invoice company. Keeping it confidential can help you maintain the strong relationships you have with your customers. But to qualify, you usually have to be a well-established, large company with a high turnover.

With ‘disclosed’, your customers pay the lender. Your invoices will also contain a note that explains you’re using an invoice company. Disclosed invoice discounting is more expensive too, due to the extra administration involved.

You stay in charge of your sales ledger and credit control

If you use either disclosed or confidential invoice discounting, you remain in charge of your sales ledger and credit control functions. Meaning you have to do things like chase outstanding invoices, which you don’t have to do with ‘invoice factoring’. You can find out the difference between invoice discounting and invoice factoring later in this guide.

Recourse and non-recourse

When it comes to invoice financing, you’re likely to come across these two terms. With a recourse facility, you are liable for the costs of any unpaid customer invoices. With a non-recourse facility (also known as ‘bad debt protection’), the lender absorbs the cost of any unpaid invoices.

Understandably, due to the higher risks of non-recourse, the lender will charge you more for providing you with this facility. Choosing between the two options will be determined by the relationship you have with your customers and their likelihood to pay you.

Example of 'disclosed' invoice discounting

You send out your invoices to your clients, together with a copy of the invoices to the lender.

The lender pays you an agreed ‘advance percentage’, which differs depending if you’re using ‘confidential’ or ‘disclosed’ invoice discounting, and your individual circumstances.

When your clients pay the lender, the lender pays you the outstanding balance – minus their fees. You can find out more about their fees in the invoice discounting costs section of this guide.

Factoring and invoice discounting

There are strong similarities between invoice factoring and invoice discounting. As with invoice discounting, you sell unpaid invoices to a lender who gives you a cash advance (normally within 24 hours) for most of the owed amount. When the invoice is paid by the customer, you receive the outstanding balance, minus a fee.

Once again, factoring can help with your business' cash flow as you don’t have to wait weeks or months for an invoice to be paid. However, there are differences between these two forms of invoice finance, which you can find out about in the section below.

The difference between invoice discounting and factoring

Do you want your customers to know?

With invoice factoring, your customers will be aware you’re using a factoring company. This is because the money they owe you gets paid into an account controlled by the factoring company. With ‘confidential’ invoice discounting, your customers won’t know you’re using this form of finance as they pay you directly.

Do you want to remain in charge of your credit control?

Another difference is a factoring company also look after your credit control. This is the process of helping ensure your debtors pay you back.

For example, if one of your customers misses an invoice deadline, they’ll be sent a reminder. If this, and several other reminders don’t work, there’s the option of legal action.

With invoice discounting, you remain in charge of your credit control. So if you’re spending a lot of time on invoicing and chasing debtors, time that would be better spent elsewhere in the business, invoice factoring with a credit control service might be beneficial to you.

Eligibility for invoice discounting and invoice factoring

Does your business have a short trading period and a relatively low turnover? If so, lenders are more likely to offer you invoice factoring over invoice discounting. This is because there’s less risk to them as they have greater control over ensuring your customers pay on time.

Invoice discounting, especially confidential invoice discounting, is only normally available to larger, well-established businesses with a high turnover.

While this is often the case, the UK government introduced legislation in September 2018 to make it easier for smaller companies to access invoice finance.

Invoice discounting costs

As with any form of lending, it comes at a price. There are two main costs involved with invoice discounting – the service fee and the discount fee.

But be aware. There might be other charges too, such as an early termination fee. The costs will also vary between individual invoice finance providers and can depend on your own business’s circumstances. It’s a cliché, but it pays to check the small print.

How invoice discounting fees are charged

Service fee

This is the cost of having the credit agreement in place and covers the management and administration of your account. It’s often calculated as a percentage of your turnover. And as your turnover changes, so could this fee.

Discount fee

Similar to the interest on a loan, this is to cover the cost of borrowing. It’s usually a few percent of each invoice that you receive an advance for. It can also be affected by how long it takes your customers to pay their outstanding invoices.

Benefits of invoice discounting

This guide has already mentioned some of the advantages of invoice discounting. In this section, we’ve highlighted them again, and noted a few others too:

  • You might be able to quickly gain access to cash tied up in owed invoices.
  • You can work to maintain your customers relationships, you’re in charge of the credit control.
  • You may get an ongoing supply of cash flow if using invoice discounting as a continuous facility.
  • You know exactly when you’re going to get paid (normally within 24 hours of submitting an invoice), giving you greater freedom to plan.
  • You may not have to worry about the borrowing requirements that come with some other forms of business lending.

What are the alternatives to invoice discounting?

Depending on your business' circumstances you may want to apply for iwoca's CBILS loan, selective invoice finance or invoice trading.

As always, chat to your accountant and get their advice, but below are a couple of other finance options you may want to consider.

Invoice factoring

We’ve already discussed this form of invoice finance earlier in the guide, so this is just a top-line overview. It works in a similar way to invoice discounting; in that you receive a cash advance from a lender for invoices owed to you. And they take a fee for providing this service.

However, the key difference is the lender is in charge of your credit control. And your customers will also be fully aware you’re using an invoice company, unlike with ‘confidential’ invoice discounting.

Selective invoice finance

Once again this works on the same principles as invoice discounting. Where it differs is that you can choose the specific customer accounts you want to finance, rather than it being ‘all’ your customers. Due to it being more targeted, it tends to be less readily available than invoice discounting or factoring.

Invoice trading

With invoice discounting and factoring, you’re likely to be tied into a long-term agreement to fund ‘all’ your invoices. With invoice trading, you upload an individual invoice to an online platform stating the amount (for example £10,000), the advance rate (perhaps 75% equating to £7,500), the maximum cost of finance (in the region of 2% per month), and the term (maybe 60 days).

Registered buyers on the platform then bid for your invoice based on this information, together with details on your background and that of your customer, and the transaction itself.

Just like peer-to-peer lending has grown in popularity in recent years, so too has the appeal of invoice trading.

Business loan

Rather than continuous cash flow management, if your business needs a one-off lump sum of cash, for example to finance an expansion plan or pay for some new equipment, then a business loan could be what you need.

You could borrow from £1,000 to £200,000 and it only takes a few minutes to apply. What’s more, similar to invoice discounting, you could receive your cash very quickly – potentially within hours.

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Martin Brackstone is a senior editor and copywriter who has years of experience writing about a broad range of topics, including business finance, pensions, home and motor insurance, premium bank accounts, reward credit cards and personal loans.

Article updated on: 22 January 2020

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