What Is Invoice Discounting And How Does It Work?

Invoice discounting service refers to the practice of borrowing money against your company’s outstanding invoices. This is the simplest form of financing your invoices. Although you’re paid a sizable percentage of the total invoice value, it’ll remain your responsibility to follow up with your clients to make sure that they pay on time.

You can think of invoice discounting as servicing short term loans in exchange for your invoices as security. Loan servicers grant these loans easily since there’s a certain level of guarantee that the money owed will be paid by the client. 

This financing method is especially convenient for businesses that wish to remain discreet about it. Confidentiality is an important part of the invoice discounting definition. 

Advantages Of Invoice Discounting

Invoice discounting can prove greatly advantageous for entrepreneurs and small business owners.

One of the biggest advantages that you can secure with this method is immediate payment. The invoice servicers generally pay up to 80% of the invoice’s value upfront. During times when cash flows are strained and finances are urgently required to clear bills and pay the staff, you’ll have to come up with immediate solutions. Generating quick invoices through invoicing software and discounting can be your saving grace.

Although invoice discounting is a kind of loan, it doesn’t affect your credit score negatively since the accounts receivables are still under your name. This makes it easy to secure loans against your invoice, unlike other means of invoice financing.

Another benefit of this finance method is the guarantee of a sizable portion of the invoice value that you get paid with upfront. Delayed invoice payment is quite common. Around 60% of invoice payments go over a week after the deadline. Although you’ll be required to pay up a small percentage of the invoice value as fees and interest, the immediate payment compensates this by keeping the cash-flow positive.

Disadvantages Of Invoice Discounting

While there are numerous advantages to this method, one can’t rule out the downsides to it. The greatest of them is the accumulation of fees and interest. You’ll be required to pay a financing fee, usually 1-2% of the invoice value. This fee is paid every month to your lender. The longer the client takes to clear payments, the higher the financing fee will be. Businesses must exclusively service loans against invoices from those clients with whom they’ve had prior working experience to ensure maximum benefit.

Moreover, collecting payment against the discounting accounts receivable from the clients is your responsibility. You’ll still be required to follow up with your clients until payments are cleared. 

Additionally, discretion will be crucial to avoid risking your business’ reputation. If clients learn about financial problems afflicting your business, they may become wary about working with you in the future.

Invoice Discounting Example

To understand this method further, let’s look at the example from the XYZ Marketing Agency. The agency has just issued a $1,000 Net30 invoice to a client. However, the business needs to secure funds urgently so it can pay bills and pay the staff. The client has a month to meet the payment deadline. Therefore, it’s unlikely that they’ll pay upfront.

XYZ Marketing Agency contacts a financing company to get into an invoice discounting agreement. The company lends 80% of the invoice’s value to the agency. This means that XYZ Marketing has secured $800 upfront. 

The agency eventually follows up with the client and receives payment before the deadline. It then returns the loan to the finance company, including interest and a 2% fee deduction. However, it’s able to keep $150. In the end, the XYZ Marketing Agency was able to secure 95% of the original invoice value.

Conclusion

Invoice discounting is a convenient method to supplement finances. Invoices come with a global history of delayed payments. It won’t be surprising if the current economic downturn further aggravates the situation. Invoice discounting along with billing software for small businesses allow users to score valuable cash upfront without having to strain the already diminishing cash-flow.