What Is Invoice Discounting? Definition and How It Works
By Indeed Editorial Team
Updated August 5, 2022 | Published August 18, 2021
Updated August 5, 2022
Published August 18, 2021
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
In business, funds often stem from the revenue of products sold or customer and client invoices and bills. Companies might use the money to invest in new equipment, keep the company operating efficiently or hire more people. Sometimes, it can take time to receive funds, which may affect business decisions or operations. To gain financing sooner, you might use invoice discounting instead of traditional loans.
In this article, we explore what invoice discounting is, analyze its benefits, show how it works with an example and discuss why you might use it in the workplace.
What is invoice discounting?
Invoice discounting is a professional accounting and financing method you can use to gain access to funds from pending invoices before customers pay them. A type of loan, invoice discounting companies lend you money, often up to 95%, for the value of your invoices. You pay the loan amount back after receiving money from the customer invoices. Invoice discounting is often confidential, meaning your customers aren't aware of it.
Traditionally, there are two kinds of invoice discounting, including:
Whole turnover invoice discounting: This financing method is when you use the entire value of your accounts receivable ledger with the invoice discount company. It can often be helpful for businesses with reliable customers and clients and provides the invoice discounting company with a wider range of risks.
Selective invoice discounting: This financing method is where you choose to discount a few invoices, like your largest account perhaps, though it's often only an option for larger companies and businesses.
Invoice discounting is a loan and differs from invoice factoring, which is a sale that happens when a company buys unpaid invoices at a discount and assumes credit control. Rarely confidential, like invoice discounting, invoice factoring involves a separate company contacting your customers to collect a payment, which might reflect poorly on your business. Invoice discounting often carries more risk than invoice factoring, and often larger companies with established customers have more access to discounting options, while smaller companies typically receive approval for invoice factoring.
How does invoice discounting work?
Invoice discounting works by partnering with a business partner that specializes in this financing method. Tied to your accounts receivable ledger, invoice discounting acts as a small loan secured on what you expect to receive. You might think of it as similar to overdraft protection in a personal bank account. Many elements of your business stay the same, like selling goods and services and collecting payment.
Here's a guide of the typical process of how invoice discounting works for a business or company:
Sell goods and services.
Create invoices for customers and clients for goods and services.
Verify invoices with an invoice discounting company.
Get advanced funds for the value of pending invoices.
Receive customer invoice payment.
Follow up with late customer payments.
Repay the invoice discounting loan, excluding the agreed-upon fees.
The invoice discounting company takes an average fee of 1% to 3% to cover the interest, risk and costs of providing the money. You can also elect to have a trust account with the invoice discounting company to have repayment directly accessible when your customer invoices get paid. Some lenders might require this because it significantly decreases the chances of nonpayment while also maintaining confidentiality. You might also refer to invoice discounting as accounts receivable financing or receivables financing.
Benefits of invoice discounting
There are several benefits that invoice discounting can provide in business. Here are some to consider:
One benefit of invoice discounting is that you get immediate access to funds rather than waiting weeks for a customer bill to get paid. This cash flow can be especially helpful for smaller growing businesses without the commitment of commercial or business loans, especially if any of your client rosters takes a long time to pay their bills. A better cash flow can often equate to a thriving and surviving business.
Affordability and simplicity
You might also benefit from invoice discounting because it's typically cheaper, faster and easier than securing traditional bank loans or capital funding. While the application processes might have similarities, you can often get approved more easily with invoice discounting than with banks. Consider researching invoice discounting firms to compare fees, prices and recommendations from past clients.
Read more: 5 Types of Funding for Businesses
Using invoice discounting also allows you to forecast predictable revenue and cash flow you can use to plan business strategy and decision-making. For example, here are some ways you might invest advanced funds from invoice discounting:
Hire seasonal staff.
Invest in a marketing campaign.
Buy additional equipment or raw materials.
You can often work with invoice discounting companies for specific lengths of time or set up seasonal contracts, depending on your business needs.
Another benefit of invoice discounting is that it’s a confidential process. Customer invoice billing and payment happen normally, even when a trust account is in place. The responsibility of collecting payment from your customers and clients also stays with you, rather than the invoice discounting company.
Invoice financing differs from traditional loans from a lender's perspective. Invoice discounting offers collateral to a lender, allowing you a better chance of gaining approval. Lenders can also reduce risks by setting parameters around how much of your invoice value they advance. For example, an invoice discount company might not give 100% of your invoice amount and rather choose to provide up to 85% of your invoice accounts.
Example of invoice discounting
Here's an example of invoice discounting using a sole proprietorship lawn care company:
Two Green Thumbs lawn care company focuses on providing landscaping and maintenance services to commercial clients. With several contracts for area hospitals, two college campuses and a sports arena, the company owner bills clients through bimonthly invoices. Because Two Green Thumbs is also looking to expand operations in a neighboring city, access to invoice funds earlier can allow the business owner to secure equipment, staff and office space. The company partners with an invoice discounting firm to get loans discretely for its existing client invoice base, gaining access to money roughly three months earlier than if the company waits for client payments alone.
Two Green Thumbs has an invoice value per quarter of $300,000 and the invoice discounting firm charges a 3% fee for their services. While this means Two Green Thumbs pays $9,000 for the invoice discounting service, the business owner finds value in getting access to the money sooner and not taking out a traditional business loan.
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