Invoice discounting, also known as invoice factoring or accounts receivable factoring, is a form of finance used by many small businesses to make available a portion of their cash flow quickly. It does this by allowing small businesses to leverage their accounts, specifically their unpaid invoices, into available capital, facilitating item purchases, business expansion, and a host of other expenditures.
This form of finance is often left unutilised by businesses, as it diverts from the more traditional forms of finance on the market. To ensure you have the relevant information to make the right choice for your business, Clarke Bell has put together a guide on the core aspects of invoice discounting.
What is invoice discounting?
Invoice discounting is a form of finance that involves the sale of unpaid invoices to a third party that specialises in invoice purchases. Such companies are often called factoring companies. The process is simple; a business wishes to free up a portion of its cash flow, and so decides to sell one or more unpaid invoices to a factoring company. The business will receive a percentage of the invoice’s value immediately, quickening the speed with which profits can be reaped. In return, the factoring company will take responsibility for collecting invoices and keep a small percentage of the value as a fee.
Invoice discounting can be conducted discreetly; a practice called confidential invoice discounting. By doing so, there will be no change in your relationship with your customers, as they won’t know that you are raising capital through a finance provider. This type of invoice discounting is not as commonly used, as it requires you to continue collecting invoices yourself. Otherwise, the factoring company will collect the invoices on your behalf.
Types of invoice discounting
Invoice discounting comes in three main forms, as we detail below.
Confidential invoice discounting
As we touched on earlier, confidential invoice discounting is conducted privately and discreetly. This ensures your customers are unaware of your use of a finance provider, nor that their invoices are being forwarded to earn you an advance payment.
Whole turnover invoice discounting
This form requires you to sell your entire catalogue of invoices, even if you only wish to sell a small number. While this method grants you access to your profits quickly, it can be excessive, even reducing your overall income through unnecessary fees.
Selective invoice discounting
This option provides a good alternative for when whole turnover invoice discounting is excessive. Using this form, you will be able to sell individual invoices, rather than most or all of them.
Invoice discounting in practice
Let’s consider a practical example. Suppose you run a business that must purchase new equipment, costing £10,000 yet doesn’t have the liquid capital available. Perhaps you have reached your borrowing limit as set by your bank, and so must look for an alternative. You have unpaid invoices, making invoice discounting an option.
Your unpaid invoices amount to £15,000. As such, you are able to sell off your invoices to immediately free this capital, allowing you to make the purchase. You contact a factoring company, which offers to purchase your invoices, keeping 4% of the value in fees. You agree, with £12,240 landing in your bank account within two days. Factoring companies usually send roughly 85% of the value in advance, with the rest being paid upon collection of the invoices. With the cash now available, you can purchase the new equipment and quickly get back to business.
Advantages of invoice discounting
Invoice discounting affords businesses a number of key advantages. It is particularly useful to small businesses and those that aim to expand in the near future. These advantages are:
- Fast access to capital – The application process is quick and easy, with minimal input required from you. Additionally, as the process is more akin to a business transaction, where you receive money in exchange for your invoices, there is little time between a successful application and cash in your bank account.
- Invoice discounting doesn’t need collateral – Unlike a lot of loans that fall into the secured loan category, it doesn’t require collateral. This is because the factoring company knows you are owed the value of the unpaid invoice, and so can safely assume they will receive their pay.
- Reduce pressure on cash flow – Small businesses especially can suffer from a tight cash flow. This can make it difficult to quickly gather the capital necessary to purchase vital pieces of equipment or fund expansions of the operation. Invoice discounting shortens the cash cycle, giving your cash flow room to breathe.
Disadvantages of invoice discounting
Of course, it is not without disadvantages. These include:
- Responsibility for unpaid invoices falls on you – Factoring companies handle the collection of invoices themselves. Normally, this goes as it usually does, the only change being the collector. However, if any of your clients continue to shirk their payment, you will likely have to buy back the invoice. Some companies, such as non-recourse factoring companies, will write off the loss.
- Potential damage to customer relations – While it can be convenient to hand off invoice collection to another, it does pose a risk. Most factoring companies have a professional level of customer service. But, once you hand over control, it’s out of your hands. If the collection goes awry, it will reflect poorly on you and your business.
- It can be costly – When compared to other forms of finance, it can be expensive. In some cases, you may be required to pay over 5% of your invoice in fees. Naturally, this reduces your overall profits, which could make be unviable for small businesses.
Is invoice discounting right for your business?
Invoice discounting is a fairly niche form of finance, one that might not be best for every business. For businesses with customers that pay on time, minimal debt, and a need for quick capital, this could be an excellent choice. However, it has considerable drawbacks, especially for businesses with clients that like to pay late. As with most forms of finance, the effectiveness lies with you and your situation.
If you operate a business that struggles with clients making late payments as a matter of course, putting your business in a precarious position financially, then turning to invoice discounting may not be the way forward. Instead, you may want to consider restructuring your business to ensure timely payments and a steadier cash flow.
We know this isn’t the easiest option to pursue. That’s exactly why we make it our business to help you with yours. Clarke Bell has worked with businesses for well over 20 years, helping to guide those with unsustainable business models onto one that allows for continued operation. To find out how we can help you, contact us today.