Invoice discounting is a form of invoice financing in which a lender provides cash based on your business’s accounts receivable ledger. These are typically short term loans that will pay a percentage of your accounts receivable in cash while you wait for your outstanding invoices to be paid by your customers. Factoring companies specialize in providing fast financing for businesses that need it, based on their accounts receivables.
Read more about factoring companies at Factoring Journal
One of the hardest things for small businesses and start-ups to overcome is the issue of cash flow. Even if you’re turning a profit, you’re cash flow situation could be entirely different. While you have to wait for your customers to pay their invoices, your overhead and operating expenses still have to be paid. Invoice discounting is one option to get the cash from your receivables almost immediately.
There are several different types of invoice financing, including invoice factoring. In all of these invoice financing situations, the business uses unpaid accounts receivable as collateral to raise cash quickly. This accelerates the cash flow from customers so that companies can continue to operate or grow.
How Does Invoice Discounting Work?
First, you work with a lender who will analyze your accounts receivable ledger to determine the percentage of cash the lender will make available to you. The lender will charge interest on the loan as well as fees for the transactions. Lenders typically make cash available within 48 hours after an invoice is issued.
With invoice discounting, you maintain control of your accounts receivable. You are still responsible for invoicing the customer and chasing down payment, if necessary. This is different from “invoice factoring” in which businesses essentially sell their accounts receivable to a 3rd party who is then responsible for collection.
With invoice discounting, when the customer pays the invoice, it will be paid into an account that’s controlled by the lender. The lender receives the full payment and pays you difference from the loan, minus interest and fees. This transaction is confidential. Your customers see a seamless payment process and are not aware of the financing.
Example of Invoice Factoring
Your business, John’s Lawn Care, contracts with XYZ Lending for factoring his receivables. Assume that you have a $100,000 invoice due.
XYZ Lending determines that they will provide 75% of the invoice amount. XYZ Lending provides you with $75,000 after you issue the $100,000 invoice.
Your customer receives the invoice and pays $100,000 to John’s Lawn Care. To the customer, it appears that they have paid the bill directly to your business.
When the invoice is paid in full, XYZ Lending will pay you the remaining $25,000, less interest and fees. The interest rate charged is typically above prime interest rate and monthly fees typically apply.
At the end of the transaction, John’s Lawn Care received payment on the invoice almost as soon as the invoice was generated. The company will pay in the form of interest and fees for the ability to access the funds immediately.
How Does It Help Your Business?
Cash flow is difficult to manage when you are waiting for accounts receivable. This is especially true for small businesses and start-ups. Many start-ups fail during the first year due to negative cash flow.
Invoice discounting will help you to manage your cash flow and provide a constant, consistent stream of cash for your business. The cash can be used to fund operations in the short term or as an investment in continued growth of the company.
What Types of Businesses Should Consider Invoice Discounting?
Although invoice discounting is a viable financing tool, it’s not right for every business. In fact, the cost of invoice discounting should be seriously considered when looking at financing options.
Typically, this type of financing is used by small to medium sized businesses in an effort to stabilize operations, especially during the early stages of the company’s existence until cash reserves can be built. This is also an option for companies that are growing quickly and need the cash to capitalize on that growth.
Invoice discounting is a good option for companies with high profit margins. Those profit margins can cover the cost of the interest and fees associated with this type of financing. If the profit margin is too low, the cost of invoice discounting could severely impact profitability.
Read more about businesses with high profit margins at Entrepreneur.com
The Bottom Line
If your business is in need of cash to cover expenses or capitalize on growth opportunities, invoice discounting may be one financing option. Using your accounts payable ledger as a form of collateral, you can gain access to cash almost immediately upon issuing an invoice. Check with lenders on the interest rates and associated fees to determine if invoice discounting makes sense for your business.