Invoice discounting works in a very similar way to invoice factoring, where a bank or other finance company takes control of a company’s sales ledger and provides short-term borrowing for the company, secured on the value of outstanding invoices. The principal difference between invoice factoring and invoice discounting is that, with the latter, the company retains control of its Sales Ledger and Invoice Book and remains responsible for debt management and collection.
Balancing the cash flow equation can be a nightmare for companies which may be owed hundreds of thousand of pounds, or even millions by companies they have provided goods and services for; particularly as many companies try to delay paying invoices for as long as possible. By raising money through invoice discounting a company doesn’t need to worry about depleting its working capital, and should find any cash flow issues disappear.
The invoice discounting process
The process underpinning invoice discounting is like that for invoice factoring.
1. A new invoice is raised and the financier is notified;
2. The financier advances a percentage of the value of the invoice to the company. The percentage rate should be specified in the contract between the financier and the company. Usually, the rate is between 80% and 90% of the value of the invoice.
3. Once the customer pays the invoice to the company, the company repays the amount advanced by the financier, plus service and interest charges.
The cost of invoice discounting
Service charge: - This is stipulated in the contract and is based on a percentage of the amount advanced, with larger advances attracting the highest charge,
Interest – As with invoice factoring, these are set
above the libor rate or the Bank of England rate, depending on the
Advantages of invoice discounting
There are a number of advantages a company can gain through invoice discounting; both advantages and disadvantages contrast with those related to invoice factoring. Advantages include:
- It is a fast, effective way for a company to raise
funds, whilst retaining control of its invoices, and credit control processes;
- Unlike invoice factoring, invoice discounting is not visible to customers. Companies can continue to build relationships with customers, and pursue outstanding invoices and debt in a way that suits the company’s ethos;
- Invoice discounting provides a type of rolling-credit where a maximum limit is set and the amount remaining available to lend increases as earlier advances are repaid; and
- Companies often find that invoice discounting dovetails nicely with its existing financial systems.
Disadvantages of invoice discounting
There is a downside to invoice discounting.
- Financiers charge for their services and, over a twelve month period, those costs, together with the cost of interest, can add up to a very significant amount which reduces company profits;
- Whilst invoice discounting can significantly improve cash flow, companies will still have to pursue late payers and bad debt;
- Financiers only advance lending on commercial invoices, not those where members of the public are parties. Furthermore they are unlikely to make advances on invoices where the customer has a poor credit history, is trading from overseas, or the invoice is for less than the minimum amount stipulated as suitable for invoice discounting in the contract between the financier and the company;
- The company may find it difficult to raise other forms of finance in addition to that raised through invoice discounting because the collateral available from outstanding invoices is no longer available; and
- Once the company has become used to having a large percentage of its outstanding invoices financed through invoice discounting, it may find it difficult to dispense with the practice.
Any company considering invoice discounting should take advice from a business consultant who specialises in the field. Because of the costs involved companies should not use invoice discounting when they do not need it. If the company is convinced that the benefits for them of invoice discounting outweigh the advantages then they should look carefully at providers who deal with the sector they trade in, and who have a good track record of lending to companies with a similar annual turnover. A company should never enter into an invoice discounting contract without both professional and legal advice. They should, of course, also be fully aware of their obligations under the contract, including the annual cost to them. The company must also make sure that the maximum amount the financier is prepared to advance is great enough to meet their needs. A financier providing invoice discounting will want to take a regular look at the processes the company has in place for invoice and credit control, together with the relevant ledgers and records.