Invoice discounting: What it is & how it works

Healthy cash flow is critical to keeping your business operating.

Unfortunately, that flow of incoming cash relies quite heavily on your customers paying their bills on time, which as we all know, doesn’t always happen.

But you’ve got your own bills to pay, and the last thing you want to do is get yourself into hot water with a supplier or financial institution.

That’s why many businesses turn to invoice discounting as a method of receiving short-term funding and circumventing the issue of late payments.

In this article, we’ll explain what invoice discounting is, how it works, and why a business would want to utilize it in the first place. We’ll also look at the advantages and disadvantages of using invoice discounting as a financial management tool, so you can make an informed decision about whether or not it's right for your business.

What is invoice discounting? 

Invoice discounting is a financial service that businesses use to access short-term financing. It involves using your unpaid invoices as collateral for funding provided by a third party.

Invoice discounting provides immediate cash flow, allowing your business to access a portion of the funds tied up in accounts receivable without having to wait for customers to pay. 

We say a portion of those funds because the financial institution or invoice discount provided typically only advances a percentage of the invoice value to the business, and of course, takes a cut when the invoice is finally settled.

We’ll explore the details of how the whole thing works shortly.

How invoice discounting can benefit your business 

Invoice discounting can be beneficial for improving cash flow.

Instead of having to wait for a customer to pay an outstanding invoice—which can be as long as 90 days, depending on the payment terms you have in place—you’re able to access those funds immediately.

This helps businesses meet their immediate expenses without incurring late payment fees. It also helps them prevent negative impacts on their credit ratings and can even reduce overall interest charges by freeing up cash to pay down debts.

Alternatively, businesses can use the cash provided by invoice discounting to invest in further growth initiatives, converting receivables into working capital and helping them maintain better financial agility and stability. 

Why would a business use invoice discounting? 

The main reason a business would want to use invoice discounting is to unlock the cash that’s tied up in unpaid invoices.

Imagine, for example, that you’re running a marketing agency, and you have Net 60 payment terms with your customers, which means they don’t have to pay you until a full 60 days after you send the invoice.

But you still have to pay your software subscriptions, freelancer and contractor invoices, and ad accounts.

Invoicing discounting allows you to access the cash that you have coming later from customer payments.

It's especially valuable for companies that deal with seasonal cash flow needs, as they can use it intermittently to avoid cash flow interruptions and take on new orders without having issues paying suppliers.

How does invoice discounting work? 

So, if you were to use invoice discounting to improve cash flow, how exactly would that process work?

Here, we examine the step-by-step process, key parties involved, and important terms to be aware of going in.

Step-by-step process of invoice discounting 

The invoice discounting process looks like this:

1. Invoice generation. The business issues and sends an invoice to its customers.
2. Application. The business applies for an advance on the unpaid invoice from the lender.
3. Funding. The lender provides a percentage of the invoice amount to the business, usually around 80-90%.
4. Payment. The customer pays, and the lender receives the full invoice amount.
5. Settlement. The business receives the remaining balance from the lender, minus any associated fees.

Key parties involved in invoice discounting 

There are three parties involved in any invoice discounting transaction:

1. Business (borrower). The company seeking funding.
2. Invoice discounting provider (lender). The company that provides the advance on unpaid invoices.
3. Customer. The business that owes payment for the invoice in question.

Important terms and conditions to consider 

Before you get involved in any kind of invoice discounting arrangement, here are a few important terms and conditions to be aware of:

• Advance rate. This is the percentage of the total invoice value the provider will advance to you.
• Fees. The services fees that the provider charges for lending you the capital.
• Recourse vs. non-recourse. Some agreements hold the business liable for unpaid invoices (resources), while others don’t (non-recourse).
• Confidentiality. Whether or not the arrangement is disclosed to customers (Confidential vs. Disclosed invoice discounting).

What are invoice discounting's advantages and disadvantages? 

Like all financing arrangements, invoice discounting comes with some important pros as well as cons.

Let’s explore both so you can determine whether it's a good fit for your company.

Advantages

Invoice discounting offers three main advantages

1. It offers quick access to cash
2. It helps businesses maintain financial independence and avoid debt
3. It allows businesses to reinvest funds and continue growing 

Disadvantages

Likewise, there are three important disadvantages associated with invoice discounting to be aware of:

1. There are fees and interest associated that reduce the net amount you receive.
2. There is a potential liability if your customer fails to pay.
3. There may or may not be available for your invoice amount or industry.

What is invoice discounting vs factoring? 

Invoice discounting and factoring are very similar, but not equal, approaches to business finances.

With invoice discounting, the lender provides a percentage of the invoice amount upfront to the business. The business is still responsible for chasing up payment. The arrangement can be undisclosed or disclosed to the customer, though it is most commonly kept confidential.

Factoring involves selling your invoices to a third party, with the third-party company taking over responsibility for collections. This is more typically disclosed to customers.

Is invoice discounting profitable? 

Invoice discounting can be profitable, but as with all financing methods, it does involve some risk.

It can be a profitable venture when it helps companies meet their growth objectives or maintain operational flow without having to accrue long-term debt.

However, there are fees involved and potential liabilities (in the case of recourse loans) which can diminish the profitability of using invoice discounting. 

What is confidential invoice discounting? 

Confidential invoice discounting is an arrangement where your customers are unaware of the fact that you’re using invoice discounting.

It is not necessary for customers to know about your use of invoice discounting, just as they don’t need to be aware of the loans or overdraft facilities you use. Because your business is still responsible for collecting payment, the customer doesn’t need to deal with the invoice discounter.

This helps you maintain independence and customer relationships without disrupting the normal payment processes or adding additional risk.

Streamline your invoicing process with BILL 

Invoice discounting can be an effective way to improve business cash flow, reduce debts, and keep business operations flowing smoothly.

However, it's not the only way to improve cash flow.

A solid cash flow forecasting software solution like BILL would be a good start, allowing you to estimate future cash flows to determine the necessity of using invoice discounting.

Additionally, having easy access to business credit, multiple payment methods for customers, and a good spend management suite are all good moves.

All of this and more is available in BILL, our financial operations platform. Discover our integrated platform today.