Are you short of cash or working capital as your customers have many due invoices? If this is the case, you can consider selling all those due invoices to a lender to receive some cash for making your working capital flow smooth and efficient. But the question is what is invoice discounting?
Invoice discounting is a widely used method many companies employ to carry a smooth cash flow. Cash flow is an essential part of a business. The shortage of cash can shut a business down and can create other hurdles like getting a loan or the next business deal.
So, we are going to explain what invoice discounting is and why your business needs a finance facility like invoice discounting. So, let’s delve deep into this interesting discussion!
What is Invoice Discounting?
Invoice discounting is a finance provision many businesses utilise to leverage their cash flow and step up their working capital, especially when their customers have many unpaid invoices. As a result, many businesses and organisations get loans from financing companies to get cash by selling their due invoices to that company.
Therefore, that financing company is responsible for achieving those due invoices by charging a service fee. Invoice discounting and invoice factoring. In this discounting process, the part of the sales ledger or an invoice is discounted by the financing company.
Why Invoice Discounting is Important?
According to one estimate by the Federation of Small Businesses (FSB), around 50, 000 small and medium-sized businesses fail due to cash flow hassles. In other words, a smooth cash flow is essential to the survival of an organisation. No business can grow without the cash lifeline.
Late payment is a financial problem common in the United Kingdom. This late payment creates financial troubles for a company. In this situation, a company can borrow money from a lending institution to provide a cushion for their cash requirements.
So, if your business has invoices due from your clients and you need cash urgently, you can use the option of invoice discounting to pay off the part of your delayed invoices. So, it’s important to keep the option of invoice discounting on your list whenever you are short on the cash as your business is more likely to fail due to cash problems.
If you are in the construction, manufacturing, wholesale and transportation, then you might need invoice discounting. Besides, a business with a higher profit margin or going smoothly on the growth trajectory can afford invoice discounting as they can pay the interest payments quickly and conveniently.
How Does Invoice Discounting Work?
Invoice discounting consists of simple steps. However, the provision of discounting all the outstanding invoices comes at a cost of interest rates plus a service fee.
- You maintain a record of outstanding invoices and accounts receivables.
- Presenting all the records of due invoices to the lender, your request for a loan will be reviewed.
- After the approval of the lending institution, they provide you with a percentage or a part of your customer’s delayed payments.
- Next, you can receive or collect all the due payments from the customer yourself or the lending institution will accept the invoices as collateral and can receive the invoices on your behalf (invoice factoring).
- A complete amount is repaid with a service fee to the lending institution after you have received complete invoices from your customers which will be more than the amount borrowed. This is because you receive a certain percentage of the outstanding invoices.
Types of Invoices Discounting
Commonly, there are three different types of invoice discounting. Let’s discuss all of them briefly!
Confidential Invoice Discounting: In this, the agreement between the vendor and the lending institution is not disclosed and it remains confidential without the knowledge of the customers.
Selective Invoice Financing: The firm can select which invoices to discount at a certain percentage. The selection of these invoices depends on a number of factors. It gives control to the firm over discounting specific types of invoices.
Invoice Factoring: Invoice factoring sells all the invoices to the lending company and they get all the accounts receivables from the clients.
Invoices Discounting Vs. Invoice Factoring
Although both methods are used to receive cash or working capital to sustain all business activities. The main difference is how the due payments will be received. In the invoice discounting method, the business entity uses the sales ledger or the invoices as collateral to get a loan from the lending institution.
On the other hand, a lending institution buys all the outstanding invoices and it is responsible for collecting all the invoices from the customers in the invoice factoring financing method. Both methods help finance a business by providing short-term loans to businesses short of cash.
Advantages and Disadvantages of Invoice Discounting
Following is a list of the advantages of invoice discounting.
- Increases the cash flow
- Small & medium-sized businesses (SMEs) can avail this financing facility.
- Funding is available on easy terms and no need to own high-value assets.
- The lending company offers flexible loan terms and options.
- Confidentiality is maintained.
- A business entity can get higher funds, avoiding the bad debt options ultimately.
However, we cannot overlook the disadvantages of financing the delayed invoices.
- It is, sometimes, difficult for smaller businesses to meet the eligibility criteria of the lending institution. However, smaller companies with a good track record of accounts receivables, profit margins, and growth prospects can get their invoices discounted successfully.
- The service fee and interest payments increase the cost of a business. The organisations must try to get due invoices as soon as possible by repeated reminders and other methods.
- Similarly, there’s no guarantee of getting all the customer’s outstanding invoices on time or on the agreed time.
Lastly, we can say that invoice discounting is a good option to finance business activities, especially when a business has a large number of outstanding invoices from its customers. As cash is an important factor and no business can grow or survive without a smooth cash flow, so invoice discounting is the best option ultimately. I hope you have learned about what is invoice discounting with its advantages and disadvantages.
Disclaimer: The information provided about What is Invoice Discounting in this article is general in nature. It does not intend to disregard any of the professional advice.