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What is invoice discounting and how does it work?

Invoice discounting gives you access to the money in your accounts receivable ledger – unpaid customer invoices – much faster. Instead of waiting for your customers to pay your invoices, you take out a short-term loan from an invoice discounting company. These companies will lend you up to 95% of the value of the invoices, paying you the money in a matter of days rather than weeks. Once you receive payment from your customers, you pay back the loan.

Invoice discounting is a method of invoice financing. It's different to invoice factoring in several ways, one of the main differences being confidentiality. Your customers need never know that you're using invoice discounting providers, whereas invoice factoring is usually harder to hide.

How does invoice discounting work?

Invoice discounting is like having an overdraft facility or a series of short-term loans secured on your accounts receivable ledger. This is how it works:

  • You sell goods or services to your customers as usual.

  • You raise invoices for those goods or services and send them to your customers.

  • An invoice discounting company lends you the value of the raised invoices, minus a small percentage, after verifying that the invoices are valid.

  • Your customers pay you according to your normal payment terms (it's your responsibility to chase late invoice payments – you remain the credit controller).

  • Once you've received payment from your customers, you repay the loan to the invoice discounting company, plus an agreed fee to cover costs, risk and interest. The fee is usually between 1% and 3% of the invoice total.

  • In some cases, your customers might pay into a trust account in your business name but actually controlled by the invoice discounting company. This reduces the risk of non-payment by you to the lender yet maintains confidentiality.

The advantages of invoice discounting

The big advantage of invoice discounting is that you know you're going to get paid quickly. This makes a big difference to your cash flow, especially if you have clients who normally take a long time to pay. Cash flow is vital to the health of your business so the better your cash flow, the more likely it is that your business will survive and thrive.

Another advantage is that invoice discounting finance is usually cheaper and simpler than applying for a bank loan – and you're more likely to be approved. With an invoice discounting service you should also have a more predictable revenue stream. This makes it easier to do business planning and forecasting, which in turn may allow you to take advantage of new investment opportunities.

The money you obtain via invoice discounting could be used in all sorts of ways: to take on temporary staff during a seasonally busy period; to buy more stock or raw materials; to carry you through a tough trading period; or to invest for the future.

The differences between invoice discounting and invoice factoring

Although invoice discounting and invoice factoring both give you an advance against unpaid invoices, they work in different ways. Invoice discounting is a loan, whereas an invoice factoring company buys your unpaid invoices at a discount. It might seem like a subtle difference, but it's an important one.

For a start, invoice factoring companies generally take over credit control. This means that they deal with your customers directly and chase late payment, instead of you doing it. That can be an advantage if you'd prefer not to focus on credit control, but it may negatively affect your customers' perception of your business.

Invoice factoring can be non-recourse, which means that if you sell an invoice to a factoring company but the customer doesn't pay, you won't have to pay back the money yourself. The fees are higher for non-recourse factoring but in some circumstances it can give you peace of mind. Because invoice discounting is a loan rather than a sale, the money must always be repaid, so non-recourse invoice discounting isn't generally available.

Invoice factoring companies will credit check your customers before agreeing to buy your invoices. This can help you weed out potential bad payers. The same isn't true of invoice discounting, for which vetting customers remains your responsibility.

There are different risk factors applying to invoice discounting and invoice factoring. Discounting is potentially a greater risk for the lender than factoring. As a result, invoice discounting is used more by large companies with reliable customers. Smaller companies tend to use invoice factoring instead – not necessarily through choice but because it's more accessible to them.

Confidential invoice discounting

Some companies prefer invoice discounting to invoice factoring because it's confidential. None of your customers need to know that you're using an invoice discounting company. This is why invoice discounting is sometimes called confidential invoice discounting. It is possible to have confidential invoice factoring as well, but this is generally less popular and more complex.

So, if you want to get paid quickly for your accounts receivable ledger but you don't want your customers to know that you're using invoice finance products, invoice discounting is probably your best option. This also leaves you in control of chasing invoices – which can be a good thing or a bad thing, depending on the creditworthiness of your customers.

How to implement invoice discounting

The first step is to decide whether you want to discount your entire accounts receivable ledger, which is sometimes called whole turnover invoice discounting. Alternatively you may choose to discount only a few specific invoices, which is called selective invoice discounting. Bear in mind that for smaller businesses it's not always possible to do selective invoice discounting. That's because invoice discounting companies prefer to spread their risk as widely as possible.

Next, contact several invoice discounting providers and compare their services and fees. If possible, ask for references from their customers. These will be anonymous in most cases but may still be useful in helping you decide which company to use. Talk to your accountant before making your final decision – they may have useful advice.

Once you've signed up with your chosen invoice discounting company, they will guide you through the process. This includes setting up payments to you, arranging a trust account for customer payments (if required) and linking into your invoicing process so that you get paid as quickly as possible. Usually, most or all of this can be done online if you're using cloud-based invoicing software.

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