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As a business owner, you need a complete understanding of any funding method you’re considering for your business. While a lot of the common terms are similar, and some are even interchangeable, there are many that are commonly confused. One such financing term is invoice discounting, which is often confused with invoice factoring. To help clarify things, we’ll cover a definition of invoice discounting, how it works, what are the disadvantages of invoice discounting (plus the advantages), and how it compares to another popular method of funding – invoice factoring.
What Is Invoice Discounting? How Does Invoice Discounting Work?
Invoice discounting is a form of accounts receivable financing that gives you healthy working capital based on your outstanding invoices in exchange for a fee. Here’s a step-by-step overview of how invoice discounting works.
- With invoice discounting, you first send an invoice to your customer.
- Next, you send the unpaid invoice to the invoice discounting company for an advance.
- The invoice discounting company gives you funding for your invoice ahead of the original payment date.
- Your customer pays you the invoice total on net terms.
- Finally, you pay the invoice finance provider the customer payment, plus the discounting fee.
Difference Between Invoice Discounting vs Invoice Factoring
Invoice discounting and invoice factoring are similar in a lot of ways, but there are some differences between them. Here’s a basic explanation of both so you can compare, then we’ll review the differences.
- With invoice factoring, a business sells their outstanding invoices to a factoring company, who keeps a percentage of the face value as their fee. The business receives working capital in days, way ahead of net terms. The factoring company then takes responsibility for collecting money from customers.
- With invoice discounting, businesses sell their outstanding customer invoices to an invoice discounting company. The funding company provides a cash advance based on a percentage of the invoice’s value. The business’ customer pays the invoice to the business, who then forwards the payment to the invoice discounting company. The invoice discounter pays the remaining balance of the invoice to the business after receiving payment.
Here are some of the differences between invoice discounting compared to invoice factoring:
- Discounting requires the business to pay the discounting company back after receiving payment; factoring requires the business’ customer to pay the factoring company.
- Discounting requires the business to manage collecting on the accounts receivable; factoring requires the business to collect on the accounts receivable (If this worries you, see FundThrough’s approach to working with your customers.)
- One of the disadvantages of invoice factoring is that it requires customer involvement; discounting does not.
- Discounting creates debt; but one of the advantages of invoice factoring is that it does not.
Invoice Discounting Advantages and Disadvantages
Like any business financing method, there are some benefits and drawbacks to invoice discounting to be aware of. Having the full picture will help you make the best choice for your business cash flow and business growth.
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Advantages of Invoice Discounting
When used correctly, invoice discounting can be a valuable tool for managing your business’ cash flow. It shares most of the same advantages with invoice factoring. Some key advantages and benefits of invoice discounting include:
- Free up access to cash flow to make payroll, purchase supplies, or take on a growth project
- Get a boost of funding any time because it is flexible
- Doesn’t create debt or require giving away equity
- Provides funding within days (much faster than traditional bank financing)
- Easier to qualify for than traditional bank financing (ideal for new businesses)
- Boosts access to liquid cash in case of an unforeseen emergency
- Helps reduce seasonal strain and any cash flow gaps
- Adds more cash to your balance sheet
- No contact with your customer
Disadvantages of Invoice Discounting
No form of financing is perfect: any funding method, accounts receivable financing, lines of credit, business loans, or otherwise. For invoice discounting, it’s disadvantages lie in its differences from invoice factoring. Here are some of the potential disadvantages of invoice discounting.
Invoice Discounting Example
It’s easier to understand how something works if we apply the concepts to a realistic situation. Here’s an example of how invoice discounting works:
You complete work for a customer, and invoice them $100K on Net-60 terms. Normally, waiting for this period of time to get paid wouldn’t be a problem, but right now you need access to capital for your business to cover payroll and purchase supplies. So, you submit your outstanding invoice to an invoice discounting provider as collateral for an advance. The discounting finance company funds your invoice with the agreement you’ll repay the advance, plus a fee of 5%. Your customer then pays you according to the original net terms. When you receive payment from your customer, you pay the invoice discounting provider $105,000 (the $100,000 invoice amount plus $5,000 for the 5% fee.)
Invoice Discounting Disadvantage #1: Invoice Discounting Creates Debt
One of the biggest disadvantages of invoice discounting is that it is more like a loan, since it uses your unpaid sales invoices as collateral. Taking on business debt comes with risks – weighing down your balance sheet, mounting interest, and the fact that business owners seeking out A/R financing solutions are trying to improve cash flow. Paying off a discounted invoice can mean helping your cash inflow today, but ultimately hindering it later.
Invoice factoring, however, is not debt because your customer pays the invoice factoring company when their invoices is due. The factoring company simply gives you an advance on your invoice, for work you’ve already completed, then handles the rest of the collections process on your behalf. (See our approach if this worries you.) Invoice factoring is not a loan, so it’s not considered debt.
Invoice Discounting Disadvantage #2: High Time and Admin Costs
Revisiting the invoice discounting process, it’s easy to see that after getting your funding, you still have to wait to get paid (or even chase payments) and then forward the payment to the invoice discount company. This means spending your valuable time – or the expensive time of someone else on your team – to handle these administrative tasks. The opportunity cost associated with invoice discounting means you’re not focusing on activities that would grow your business.
With invoice factoring, you are not the middleman for payment. Your customer pays the invoice factoring company directly. Understandably, some business owners worry that a factoring company will damage valuable business relationships. At FundThrough, we always talk to you first about how to handle a late payment before we contact your customer. See our approach if you’re worried.
Invoice Discounting Disadvantage #3: Low Advance Rate and Hidden Fees
When looking at whether or not invoice discounting is the right financing option for your unpaid invoices, it’s also important to look out for hidden costs. Some invoice discounting companies (and even factoring companies too, to be fair) will bring in clients with low ‘teaser’ discount rates, which leave out other hidden fees.
These additional service fees may include monthly minimums, administrative fees, application fees, proposal fees, due diligence fees, credit checking fees, late payment fees, notification fees, schedule processing fees, and more. They may be hidden in the fine print of your contract, so read carefully before signing agreement terms, as additional costs can add up quickly and cut into your advance percentage.
In that same contract, you’ll also need to get clarity on the advance rate, which is the amount of funding the invoice discounter will give you immediately, before they get paid back. (They will pay you the rest, minus their discount fee, after getting your customer’s payment.) Sometimes this can be as low as 80 percent. If you need a specific amount of capital from your invoice, you’ll need to ensure you have a high enough advance rate.
This is why doing your research is key to understanding overall total costs, and that you’re working with the best partner for your business. These best discounting and factoring providers will be upfront about their prices and fees so you can make an informed decision. Learn more about invoice factoring rates, as well as invoice factoring benefits and drawbacks.
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FAQs
What is the average rate for invoice discounting?
The average rate for invoice discounting is usually anywhere from 2.5-6% depending on the invoice payment terms and the finance company’s policies. When you need a quick cash injection for your business, invoice discounting can help with improved cash flow.