Invoice Finance Fundamentals: What is Invoice Discounting and How Does It Work?

This offers businesses a way to bridge the gap between the time when they provide goods and services and when they receive payment.

A lender advances most of the invoice value upfront, then collects its money when your customer pays. In short, ID releases cash tied up in unpaid invoices before your customers actually pay them.

This article is part of our Invoice Finance Fundamentals series, for businesses considering using invoice finance for the first time.

What are the benefits of invoice discounting?

Invoice discounting smooths cash flow and provides valuable working capital, freeing you to pay wages, suppliers and other expenses without waiting for customers to pay you. It’s an important tool if you’re planning to grow, take on bigger projects or have unexpected costs to pay.

Unlike an unsecured loan, which is based on projected but currently unrealised future earnings, ID is secured against money you’ve already earned. This makes it typically lower risk and easier to repay than a loan.

An ID facility also automatically grows as your sales grow, making it more flexible than other forms of finance such as an overdraft. 

How does invoice discounting work?

Once an invoice discounting facility is in place, you inform your lender of the value of all your outstanding invoices on a regular basis – usually monthly. An increasing number of lenders are able to connect to borrowers’ accounting systems via secure Open Accounting technology. With this in place, you don’t have to report anything – your lender picks up your required invoice data automatically.

Once they have your ledger figure, the lender advances you a percentage of the total value of your outstanding invoices. The percentage is usually up to 90%, depending on circumstances, and is often paid within 24 hours.

You are responsible for ensuring the unpaid invoices are paid by your customers, and you will need to chase any that are overdue. Once payment is received, you repay the lender the amount borrowed plus interest and a fee.

Here’s an example:

Imagine you run a business supplying electrical services to construction companies.

1. You install electrical systems in a new development and issue an invoice for £10,000, payable in 60 days.

2. You have salaries and bills to pay, so instead of waiting for 60 days, an invoice finance lender advances you £8,500 (85% of the invoice value).

3. After 60 days, your customer pays the full £10,000 invoice to your business.

4. You repay the £8,500 the lender lent you, plus their fees and interest. 
 

What type of business is invoice discounting suitable for?

Invoice discounting is suitable for businesses that do their work before getting paid – in other words provide goods and services on credit. It is especially valuable for businesses that have reliable customers and want to improve cashflow, but would rather not hand control of their sales ledger to a lender.

Here are some of the kinds of businesses that benefit from ID:

• Manufacturers – they pay for materials, labour and production before their customers receive the goods. 
• Wholesalers and distributors – they usually have tight margins and often long payment terms.
• Transport companies – they incur fuel, vehicle and driver costs upfront, while customers may pay much later.
• IT and professional services businesses – they often have large corporate clients with lengthy payment terms up to 60 days or longer, but must pay employees in the meantime.

The ideal invoice discounting customer might be a well-established business with substantial B2B sales, creditworthy customers, predictable invoicing and an effective finance team.

ID is often not as suitable for new businesses, those with troubled financial histories, or those that don’t have internal teams to manage invoice collections.

When would a business use invoice discounting?

Invoice discounting is particularly useful for a business that has plenty of sales but needs cash to meet immediate costs. For example, you may have invested in new equipment or embarked on a phase of growth and recruited a bigger team. In both cases, getting hold of money owed early boosts the cash you have available to spend on investing for the future.

Here are some typical scenarios:

• Rapid growth – more stock needs to be bought, staff hired and production increased before customers pay for your work.
• Seasonal peaks – you need to build stock or recruit temporary staff ahead of your busiest trading period.
• A large new contract – you have to spend before you’re able to invoice. 
• Unexpected cash-flow pressure – a major customer delays payment, leaving you temporarily short of funds despite a healthy order book.
• Expansion into new markets – you incur costs well before you’re able to do work and invoice for it.
• Shifting from using an overdraft – if you’re growing but your overdraft is fixed, you may want a funding facility that grows as your sales grow.
• Pay off a larger than expected tax bill (or other bill) – you need some extra funds to cover the money you owe.

What different types of invoice discounting are there?

Bulk invoice discounting: the borrowing facility is secured against the total value of unpaid invoices – the lender does not see or assess individual invoices.

Shadow ID: a ‘shadow ledger’ is operated by the lender – a duplicate ledger that lists all invoices, giving the lender visibility at a granular level.  

Selective invoice discounting: you choose particular invoices to fund, rather than putting the whole ledger through the facility.

Want to find out more?

Invoice discounting is a simple, cost-effective way for established businesses to access cash using their most accessible asset – their invoices.

Other types of invoice finance are available and may be more suitable for your business. To find out more, access our Invoice Finance Fundamentals series or contact your commercial finance broker today.

About Dancerace

Dancerace is the complete, connected software platform for banks and lenders providing invoice finance products – including invoice discounting. Today, 4/5 of the UK’s highest-rated IF lenders depend on Dancerace to power their IF business.