What is invoice discounting?

Invoice discounting occurs when a Client (“the Client”) enters into an agreement with another business (“the Invoice Discounter”) in terms of which the Client cedes its book debts to the Invoice Discounter, generally on an ongoing basis, for up to 80% of its total value.

• The Client retains management of the sales ledger and its customers are unaware of the existence of the Invoice Discounter.

• It is a form of short-term borrowing often used to improve a company’s working capital and cash flow position. Invoice discounting allows a Client to draw money against its sales invoices before the customer has actually paid. To do this, the Client borrows a percentage of the value of its sales ledger from an Invoice Discounter, effectively using the unpaid sales invoices as collateral for the borrowing.

• Although the end result is the same as for factoring (the Client gets cash from its sales invoices earlier than it otherwise would) the financial arrangement is somewhat different. Unlike factoring, when an invoice is discounted, the debt is not sold to the Invoice Discounter. Instead, the Invoice Discounter advances a percentage of the debt to the company, who remains the owner of the debt. As security, the Invoice Discounter takes cession of the Client’s book debts.

• Responsibility for raising sales invoices and for credit control stays with the Client, and the Invoice Discounter will often require regular reports on the sales ledger and the credit control process.

• Whilst this financing option is ideal for the more established Client, it is of very little benefit to Clients with smaller debtor books and little in the way of asset or balance sheet collateral.

• Single invoice discounting is a financing facility designed specifically for undercapitalised Clients as it facilitates access to finance with as little as one selective invoice required as security for the advance, although a solid contract, strong/blue chip debtor and clear credit record are also necessary.

Features

• When a Client enters into an invoice discounting arrangement, the Invoice Discounter will allow the Client to draw down a percentage of the outstanding sales invoices – usually in the region of 80%. As customers pay their invoices, and new sales invoices are raised, the amount available to be advanced will change so that the maximum drawdown remains at 80% of the sales ledger.

• The Invoice Discounter will charge a monthly fee for the service, and interest on the amount borrowed against sales invoices. In addition, the Invoice Discounter may refuse to lend against some invoices, for example if it believes the customer is a credit risk, sales to overseas companies, sales with very long credit terms, or very small value invoices. The lender will require a floating charge over the book debts of the Client as security for the funds it lends to the Client under the invoice discounting arrangement.

• Invoice settlement, furthermore, results in the immediate release of the 20% of invoice value held back as security against, for example, overdue accounts.

• Invoice discounting is targeted at larger companies with established systems and an expected substantial annual sales turnover. Providers will need to be satisfied that the client can manage their own sales ledger administration and credit control facilities.

Benefits

• By receiving cash as soon as a sales invoice is raised, the Client will find that its cash flow and working capital position is improved.

• The Client will only pay interest on the funds that it borrows, in a similar way to an overdraft, which makes it more flexible than debt factoring.

• Invoice financing can be arranged confidentially, so that customers and suppliers are unaware that the Client is borrowing against sales invoices before payment is received.

Drawbacks

• In some industries, financing debts can be associated with a company that is in financial distress. This can result in suppliers becoming reluctant to offer credit terms, which will reverse many of the benefits of the arrangement.

• Invoice discounting is an expensive form of financing compared to an overdraft or bank loan.

• As the Invoice Discounter takes a legal charge over the sales ledger, the Client has fewer assets available to use as collateral for other forms of lending – this may make taking out other loans more expensive or difficult.

• Once a Client enters into an invoice discounting arrangement, it can be difficult to leave as the Client becomes reliant on the improved cash flow.

AN EXAMPLE

ABC factory has made shoes and has delivered them to its customer, the retail shoe shop. ABC has granted the retail shop 90 days credit but ABC factory needs its money now.  Invoice bridging / Invoice Factoring / Invoice Discounting is when the bridging company advances up to 80 % of this money to ABC factory and then collects the money from the retail shop in 90 days time. The fee for the period the money was lent out is deducted from the 20 % still due to ABC factory and the difference is paid to ABC factory.