Invoice discounting is a type of short term cash flow finance option which allows a business to gain access to instant funds secured by the value of their accounts receivable ledger. A business line of credit can be extended to a company generally for a percentage of the total ledger’s value (usually 75-80%). As invoices are paid, this credit amount is automatically repaid and allows for redrawing against new invoices created and awaiting payment.
It acts a revolving line of credit more closely aligned to a business’ expected income and so is designed to reduce cash flow strain and free up money for investing in new growth opportunities as well as helping to cover day to day expenses.
Payment terms create cash flow gaps
When a business provides goods or services to their customers, they issue an invoice along with those products or services. Payment terms are the agreed upon waiting period that a business must wait before that invoice is paid. In the intervening time, however, that business still has operating costs to pay like overheads, payroll demands and working capital. The time between the invoice being issued and it being paid accounts for the cash flow gaps that invoice discounting can help to close.
Invoice discounting helps to solve cash flow issues not only because businesses are not forced to wait 30 days or more for payment from their business customers, but also because repaying the credit amount doesn’t further strain cash flow resources.
A business loan must be repaid within a fixed repayment schedule. This must be factored into cash flow projections and can potentially compound already established issues. And, unlike an invoice factoring arrangement, the lender offering discount facilities is usually not disclosed to a business’ customers. This ensures that important customer relationships remain unaffected and the business is able to access the funds it needs discretely.
A shortage of working capital is a serious problem for most businesses. Cash flow problems are a headache for almost 50% of companies in Australia. With credit terms on invoices sometimes up to 90 days, being able to secure funds against them provides an instant cash boost that can be put to work straight away.
Invoice discounting is often known by other names, including invoice finance, accounts receivable finance or debtor finance. These terms actually describe the broader category of invoice financing and of which invoice discounting is a specific type. Invoice discounting is very similar to factoring, with a couple of key differences which we’ll explore in this article.
How it works
Invoice discounting generally works like this:
During the application process, the finance provider will review a company’s sales ledger as part of their lending criteria checks. The sorts of things they are looking for include the concentration of debtors on your ledger, their creditworthiness and the age and value of invoices. It is generally considered better to have multiple debtors spread over multiple invoices rather than a concentration of only a few debtors.
Based on the information they glean from your accounts receivable ledger, they will advance you a proportion of that ledger’s value which is usually around 75-85%. They will then set up a new receivables account for your business where the outstanding invoices you have financed must be paid into. Once the outstanding invoices have been paid, they’ll then remit the outstanding balance, minus their fees.
This kind of credit is designed to grow with a business. As more invoices are raised, more funds become available without the need for further credit applications and additional credit checks.
Types of invoice discounting
There are a few different types of invoice discounting:
This is the most common form of invoice discounting, where the facility is not disclosed to a business’ customers. This allows a business to manage all of their customer relationships as normal, offering a discrete boost to cash flow. It also means that collecting debts remains with the company, which may be a pro or a con, depending on the kind of credit control resourcing is available.
Alternatively, there are finance facilities available in which the arrangement is known to customers, however, the lender does not assume responsibility for collecting invoices and that remains with the company.
For invoice discounting facilities, funds are usually raised against the entire accounts receivable ledger. However, selective invoice discounting allows individual invoices or customers to be selected for financing instead.
Factoring and invoice discounting
An alternative to invoice discounting is factoring. Both offer funds secured against a company’s accounts receivable ledge and they share many of the same benefits. Companies receive access to a quick cash flow boost, there are no fixed assets used as security, and it’s a relatively fast and simple application process. But there are a few key differences:
|Invoice Discounting||Invoice Factoring|
|You remain in charge of credit control and collections||The factoring company manages credit control and collections|
|Suited to / available for larger businesses, with less need for admin help||Suited to / available for smaller businesses, who may need help with their bookkeeping|
|The accounts receivable ledger is not sold, but funds are drawn against it||The accounts receivable ledger is sold to the lender|
|Clients are usually unaware of the need for finance||Clients are usually aware of the need for finance|
|Cheaper than factoring||More expensive than discounting as it includes additional services|
|Customers pay the business as usual||Customers pay the factor|
|Business stays in control of client relationships||Factoring companies can interfere with precious client relationships|
|Riskier for lender as no contact with debtors||Less risky for lender as they manage collections|
|Almost always involves the entire invoice ledger||Can be full ledger or single invoice factoring|
The advantages and disadvantages of invoice discounting
|Improved cash flow, allowing you to fulfil orders, pay staff, cover operational costs and grow||Whilst it is cheaper than factoring, it is still expensive compared to other forms of finance|
|It grows as you do. As more invoices are raised, the amount available increases||Unlike factoring, no admin support (although this is an advantage too)|
|Fast funds - often the business receives funds in 24 hours||Often unavailable to smaller businesses|
|Doesn’t require any fixed assets as collateral||The entire ledger is usually funded, rather than individual invoices or clients|
|You stay in control of credit and collections|
|The lender does not interfere with your client relationships|
|Can take the form of a line of credit, allowing businesses to draw and redraw endlessly|