Sourcing finance for projects and purchases is a vital goal for every business, especially small ones. Cash flow is often tight, making it difficult to free up enough capital in order to fund an expansion project or make an important purchase, such as updating equipment. This makes finding the right finance option an important task, though one that is easier said than done. There is a wide range of different options for raising capital, each with its own advantages and disadvantages. Therefore, finding the best one for your situation can be challenging.

Invoice discounting is one form of finance that every business owner should be aware of. It affords businesses a unique advantage: using unpaid invoices to raise capital. This can free up even the most tightly constrained of cash flows, allowing any business, from big to small, to make use of otherwise inaccessible capital.

In this article, we will discuss invoice discounting, how it works, and the advantages it could grant your business. Let’s get started.

What is invoice discounting?

Invoice discounting, not to be confused with invoice factoring, is a type of invoice financing that allows you to tap into your business’s unpaid invoices for capital. This is done by essentially using your client’s unpaid invoices as collateral for a loan. This is typically done through a finance company, which will loan you a certain percentage of your unpaid invoices’ value while using them as collateral.

Invoice discounting is a very short-term form of finance. You will receive a set percentage of the overall value of your unpaid invoices, with those invoices being used as collateral. You will be expected to repay the value of the loan plus interest once those invoices are paid, which can make invoice discounting loans last as little as one month for some businesses. Also, you remain responsible for collecting these invoices, unlike invoice factoring. As such, it’s not an ideal solution for businesses requiring a long-term form of finance.

What is invoice factoring?

Invoice factoring is a similar form of finance that is often confused with invoice discounting. It has similar operating principles to invoice discounting, as your business’s accounts receivables are used to raise capital. However, there are noteworthy differences between the two methods.

While invoice discounting uses unpaid invoices as collateral for a loan, invoice factoring sells unpaid invoices outright. The sale will typically be between a business and a factoring company, with the latter paying the former most of the invoices’ value upfront. The factoring company will then collect the unpaid invoices on behalf of the business, paying most of the rest of the value afterwards. A factoring fee, typically around 4%, will be deducted from the total value of the unpaid invoices, leaving the business with roughly 96% of the unpaid invoices’ value after collection.

As the two methods differ notably, you should carefully consider which one is best for your situation. Invoice discounting offers a short-term loan tied to your clients’ unpaid invoices, while invoice factoring offers two lump sum payments, which will be paid out at different times.

How does invoice discounting work?

Invoice discounting is a simple and effective method of raising capital, one that is unobtrusive to your business’s operations. It largely follows the same process as a normal invoice collection, with only a couple of extra steps.

First, you will need to iron out an agreement with a finance company. This will determine what unpaid invoices you will use as collateral, the loan’s value, and the repayment term. The finance company will then release the value of the loan to your company, freeing up your cash flow.

Later on, you will collect the payment your clients owe you as normal. Once you have done so, you must repay the value of the loan, plus interest and any fees. Fees tend to be no more than 3% of the overall unpaid invoices’ value. Repaying your invoice discounting loan plus interest and fees marks the end of it. At this point, you could choose to renew your loan, repeating the process with another set of invoices, or you could leave it as a one-time supply of quick capital.

While this roadmap tends to be how most invoice discounting loans work, some can differ slightly. In some uncommon cases, a business’s clients can indirectly pay the finance company by paying into accounts owned by them. The accounts will still be in your business’s name, however, so your clients will not know that you have engaged the services of a finance company. The process works much the same as outlined above, with the only difference being that your clients will pay into this account instead of paying you directly for the invoices. The finance company will then deduct the loan plus interest and fees, then release the rest to you.

Advantages of using invoice discounting

There are some considerable advantages to using invoice discounting as a means of raising capital. Here are three of the most beneficial:

  • Freeing up capital – The biggest advantage to using invoice discounting is that money trapped in a tight cash flow is released. This can help you fund equipment purchases, stock purchases, or other expenses without resorting to other forms of finance.
  • Confidentiality – As you remain responsible for collecting your clients’ unpaid invoices, they do not know you are using a finance company. This shelters you from any public relations fallout from using finance services, as they might think your company has run into financial problems. This is in contrast to invoice factoring, wherein the factoring company is responsible for collection.
  • Inexpensive – As invoice discounting is a very short-term method of finance, it is fairly inexpensive. You won’t be exposed to a lengthy loan term with hefty interest payments, given that the process is generally only a few months long at the latest. Fees are also typically quite low, though the exact cost depends on your particular lender.

Wrapping up

Invoice discounting is a simple yet effective method of raising finance, and is especially beneficial for small businesses with a tight cash flow. It allows you to release money trapped in your cash flow, freeing it up for immediate use. This is invaluable for small businesses looking to expand, or for when you need to make an emergency purchase. However, although it doesn’t have some of the disadvantages as its counterpart, invoice factoring can provide some additional advantages. As such, you should carefully consider which of the two is best for your situation before taking action.