What is Invoice Discounting and Its Importance

Invoicing software

The invoice discounting method of financing provides businesses with much faster access to money in their accounts receivable ledger for any unpaid customer invoices. Rather than wait for customers to clear their dues towards the sales invoices, businesses can avail of a short-term loan from the invoice discounting company up to 95% of the invoice value. It takes only some days to get the money which otherwise would take weeks. The invoice discounting company is paid once the customer makes payment around the due date.

Invoice discounting refers to a method of invoice financing. It varies from invoice factoring in many ways. One of them is the matter of confidentiality. The customers do not know that their supplier uses the invoice discounting method. On the other hand, invoice factoring is generally difficult to hide.

Working model of invoice discounting finance

Invoice discounting is similar to taking an overdraft facility or a stream of short-term loans mortgaged by a company’s accounts receivables. 

Step 1: The company sells products or services to its customers.

Step 2: The company raises invoices for those products or services sold and shares them with relevant customers.

Step 3: The invoice discounting company finances the invoice value less a small margin upon verifying the validness of those invoices.

Step 4: The customers pay towards invoices as per the regular payment terms (the company is responsible for following up for any late invoice payments. Hence, they continue to be credit controllers).

Step 5: Once the company has received payment from the customers, they repay the loan to the invoice discounting company, together with a pre-decided fee to compensate for costs, risk, and interest. The fee generally ranges from 1% to 3% of the total invoice value.

In a few cases, the company’s customers may have to pay into a trust account in its name but controlled by the invoice discounting company. It reduces the non-payment or default risk towards the lender while still maintaining confidentiality.

Invoice discounting benefits

A huge advantage of invoice discounting is the assurance of being paid faster. It creates enough positive impact on the cash flow, more specifically where there are clients who generally take a long period to pay. Cash flow is crucial for business health. Accordingly, if the company’s cash flow is better, it increases the business’s likeliness to survive and thrive.

Another benefit is that invoice discounting finance is generally cost-effective and easier than going for a bank loan since there is a higher probability that the company will be approved. The invoice discounting finance allows a company to have a better predictable revenue source. It makes it convenient to conduct business planning and budgeting. These eventually allow the company to take benefit from fresh investment opportunities.

The money that the company obtains through invoice discounting may be utilized in several ways, such as follows-

  • To have temporary staff at the time of a seasonally busy period
  • To purchase more inventory or raw materials
  • To help the company operate during a rough trading period 
  • To invest in the future.

Comparison between invoice discounting and invoice factoring

Although both invoice discounting and invoice factoring provide companies with advances against unpaid invoices, they operate differently. Invoice discounting is considered a loan, whereas an invoice factoring company buys your unpaid invoices at a discount. These may look like a small difference but is vital.

To begin with, invoice factoring firms often take over credit control. It implies that instead of a company such as yours, they engage directly with its clients and follow up for late payments. It can be beneficial if the company doesn’t want to bother about credit control. However, it may negatively impact the customers’ opinion of the company.

Non-recourse invoice factoring means that the customer fails to pay if one sells an invoice to a factoring business. They would not have to pay the money back themselves. Non-recourse factoring has higher fees, but it might provide them with peace of mind in particular situations. Because invoice discounting is considered a loan rather than a sale, the money must be repaid. Hence non-recourse invoice discounting is uncommon.

Before agreeing to acquire a company’s bills, invoice factoring providers will run a credit check on their clients. It can assist the company in weeding out poor payers. It isn’t the case with invoice discounting, where the company is still in charge of verifying customers.

There are various risk concerns to consider when it comes to invoice discounting and invoice factoring. For the lender, discounting may provide a bigger risk than factoring. As a result, major organizations with dependable customers are more likely to adopt invoice discounting. Invoice factoring is more popular among small businesses, not because it is more convenient but more accessible.

Confidential invoice discounting

Because invoice discounting is more secret than invoice factoring, some businesses prefer it. The customers don’t need to know that the company uses a discounting invoice service. Because of this, invoice discounting is often known as “secret invoice discounting.” It is also feasible to have confidential invoice factoring, but this is less common and more difficult.

Hence, if the company wants to be paid faster for its accounts receivable balance but does not want its customers to know that they’re using invoice finance products, then invoice discounting is likely the best option. It also leaves the company in control of following up for invoice dues which can be a positive or a negative thing, depending upon the creditworthiness of its customers.

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Implementation of invoice discounting

Step one is to take a call on whether the company wants to discount its entire accounts receivable balance, which is also referred to as whole turnover invoice discounting. On the other hand, you may discount a few particular invoices, known as selective invoice discounting. 

Small businesses can’t go for selective invoice discounting. It is because invoice discounting companies want to spread their risk broader than possible.

Next, contact many invoice discounting financiers and verify their services and fees. Contact their customers for references and testimonials. Such actions will be done in anonymity in many cases. Still, it may be beneficial to let the company decide which financier to choose. Please chat with the company’s accountant before taking a final call, as they may provide useful advice out of their knowledge and experience.

Once the company has signed up with the preferred invoice discounting financier, they will guide the company through the process. It includes payment setting up, Going for a trust account for customer payments (if needed), and merging into its invoicing process for a quicker payment. Generally, most of this is available online, and hence would be convenient to use cloud-based invoice software.

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