Invoice discounting is a form of external funding, falling under the umbrella of invoice finance. It is designed to ease cash flow in businesses by alleviating the issue of late customer payments that plagues many SMEs.
Invoice discounting is incredibly valuable to businesses struggling with cash flow but not wanting to alarm their customers. We’ve created a brief guide to explain how it works, who it helps, and the benefits to be unleashed.
What is invoice discounting?
Invoice discounting is a form of lending that uses your unpaid invoices as collateral. The lender will lend against this collateral, usually up to 90% of the total amount of your invoices, depending on the terms of the deal.
The loan is repaid when the client pays you. Again, the exact length of loan will vary based on terms, though it typically ranges from 30 to 120 days from the date of the invoice or month end. Ideally, your customers will have paid you by this point. If not, the funds available to be drawdown will be reduced.
Unlike invoice factoring, confidential invoice discounting retains privacy by not disclosing to customers that you are working with an invoice finance facility. You will still receive payments from your customers but they will be paid into a trust account under the lender’s control.
It’s also possible to use invoice discounting across single or selective invoices as well as across your whole debtor book and raise your overall funding level.
Generally, invoice discounting is used by companies that want to inject capital into their companies and is used in both growth and turnaround scenarios. If this sounds like your business, it could be a perfect solution.
Five benefits of invoice discounting
Invoice discounting carries many benefits for businesses, including:
Full confidentiality
Although external finance is used by many businesses to fuel cash flow and growth, there is still a stigma attached. Companies may be unwilling to disclose that they are working with a lender for fear of alarming customers and other stakeholders about their financial stability, but the reality is that every business will have cashflow issues from time to time.
Invoice discounting is ideal in these scenarios as you do not need to disclose that you are working with the invoice finance facility. Customers will continue to make payments to your new trust account, so there is no need to alert them to the role of the lender. It enables you to maintain confidentiality.
An added benefit of this is that you retain control of your customer relationships without the interference of a third party. Doing so will allow you to maintain customer experiences and prevent ill sentiment.
Cost-effectiveness
Invoice discounting is highly cost-effective. It’s cheaper than an overdraft or most other lending streams.
There are some charges you will need to pay though these tend to be low. Discounting typically has lower fees as you will be chasing up debt internally rather than the lender.
The fees make invoice discounting a financially responsible choice while enabling you to boost cash flow as and when needed.
Boosts cash flow
The primary purpose of invoice finance is to ease cash flow pressures facing your business. As we’ve already touched upon, many SMEs must deal with delayed payments from customers. This quickly leads to issues which make it harder to meet your financial commitments consistently.
Invoice finance injects capital into your operations to overcome late payments and keep things moving smoothly. If you have an invoice discounting facility, the funding levels rise and fall with the turnover of the business and the business has the ability to drawdown the funding as and when it requires it.
Grows as your business does
As your business grows, your sales volumes will too. Higher sales will invariably mean increased costs and potential cashflow pinch points. You need to balance the growth with cash flow management.
Fortunately, invoice discounting will grow alongside your business. You will have more invoices to utilise, each of which can be used as security to raise funding. The higher the value of your outstanding invoices you have, the larger the level of funding you will have access to – as the size of your facility grows you may also be able to get more favourable terms.
It also helps you to mitigate the risk of onboarding new customers, as the business grows. Invoice discounting will ensure that, even if customers are late with payment, you have a way to raise capital to maintain cash flow as your operations expand.
Offers quick and easy access
Receiving funding through invoice discounting is a fast process, particularly compared to other forms of finance such as bank loans. You will sometimes receive capital in as little as 24 hours.
If you need a quick release of finance, it’s an ideal option.
It’s also worth noting that invoice finance is accessible to most companies who have B2B customers. The only thing you need is your customer debtor book. There may be a need for a personal guarantee, but the amount can be negotiated. This makes it easy to access and allows a broader group of businesses to be eligible.
Three things to bear in mind
Alongside the benefits, there are factors to consider to check if invoice discounting is the best choice for you. We’ve listed the three most prominent below.
Getting customer payment
In an invoice discounting agreement, you are responsible for chasing customer payment. Although the loan given is a temporary fix, it needs to be repaid – which means you must get what you’re owed from your customers.
If a customer doesn’t pay you back, it could leave you unable to clear the balance with the lender, which will place you back at square one.
You must be confident that you will secure payment from your customers. Having robust credit management protocols, including a system for chasing up invoices, will help.
Securing terms and rates that work for you
An invoice finance facility has set terms that dictate how much lending you receive per invoice, when the loan needs to be repaid, and other conditions.
Shop around different lenders and deals until you find the most competitive terms. Typically, it will be those that offer you the highest amount of funding against your invoices with minimal fees and a repayment timeframe that gives you time to collect customer payments.
Remember to keep your specific needs in mind and find an option that suits them.
Understanding the charges
We already mentioned there are some fees associated with invoice discounting. Although these are usually low-level, it is still vital to know what they are in advance.
Examples of charges include:
- Discount charges – usually 2-5% over the lender’s base rate depending on your credit rating, financial performance and service provided
- Service fees – may be fixed or based on percentages. In the case of discounting, you can expect costs of around 0.2-1%
- Trust, CHAPS and other fees – fees associated with the setting up of a trust account for funds to be paid into, as well as CHAPS and BACS payments
- Credit protection charges – usually around 0.5-2% of turnover, if you have a non-recourse arrangement with the lender
- Other fees – there may be some additional fees, including audit, arrangement and termination fees
It is best to discuss with the lender how they charge fees. Comparing fees is also helpful for finding the most competitive deal.
In summary
Invoice discounting is a valuable form of external finance for businesses facing the issue of late payment and its knock-on effects on cash flow. Using it will enable you to inject capital into your company when needed while maintaining confidentiality and control of customer relationships.
However, it’s crucial to consider if it’s right for you and research providers to find the best terms for your needs. Some businesses will benefit from invoice factoring, so it’s worth contemplating this alternative option.
If you want an invoice discounting facility for your business, Pegasus will connect you with suitable sources through our extensive funding network.
We’ll also work with you to negotiate terms that suit your unique requirements and offer you precisely the support you want.