Invoice Discounting

Invoice discounting is a way for a business to raise cash against the money its customers owe it. The business sells or assigns its unpaid invoices to a finance provider, which advances a large part of their value straight away and pays the remainder, less charges, when the customers pay. The business continues to run its own sales ledger and to collect payment, and in the usual confidential form its customers are not told that the invoices have been financed.

It is one of the main forms of receivables finance. It differs from factoring, in which the finance provider also takes over credit control and collects from customers directly, so that customers know of the arrangement. Invoice discounting is offered by banks and specialist finance companies, mainly to established businesses that sell on credit to other businesses and have reliable accounting systems.

The business enters into a facility agreement, often a receivables purchase agreement, covering all of its eligible invoices or, in some products, selected ones. As it raises invoices it notifies the provider, usually by uploading sales ledger data. The provider makes funds available up to an agreed percentage of the eligible invoices, commonly between 70 and 90 per cent, known as the advance rate.

Customers pay as normal, but into a bank account held in the business's name on trust for the provider, or controlled by it. Each receipt reduces the amount borrowed, and the balance not advanced becomes available to the business after deduction of fees. Because new invoices are added as old ones are paid, the facility revolves and grows with sales.

The provider protects itself with conditions on which invoices count. Typical exclusions are invoices overdue beyond a set number of days, sales to associated companies, invoices subject to dispute or to contractual restrictions on assignment, and amounts above a limit for any one customer, which guards against concentration risk.

There are two main charges. A discount charge, which is in effect interest, is applied to the funds drawn, usually at a margin over a reference rate. A service or administration fee is charged as a percentage of turnover or as a fixed periodic amount; it is lower than in factoring, since the provider does not perform collections.

• Confidential and disclosed. Most facilities are confidential. In a disclosed facility, invoices carry a notice of assignment and customers are told to pay the provider's account.
• With and without recourse. Under recourse terms, the business must repay advances on invoices that customers fail to pay, as in recourse factoring. Without recourse, the provider bears the loss from a customer's insolvency up to agreed limits, usually by including trade credit insurance.
• Whole turnover and selective. A whole turnover facility covers the entire ledger. Selective or spot discounting finances chosen invoices or customers, at a higher price per invoice.
• Export. Facilities may cover foreign customers and currencies, sometimes with partner financiers abroad, as an alternative to export bill discounting.

Invoice discounting is often one part of an asset-based lending package that also lends against stock and equipment.

The main advantage is faster access to working capital: cash arrives within a day or two of invoicing instead of after the customer's payment period. Funding rises automatically with sales, which suits growing companies whose overdraft limits would not keep pace. The business keeps control of customer relationships, and confidentiality avoids any signal that it is using its debts as security.

The drawbacks are cost, which is often higher than a conventional overdraft; the administrative demands of reporting to the provider; and reliance on a facility that shrinks when sales fall or when receivables age, just as cash may be tightest. The provider normally takes security over the debts and often over other assets, which limits other borrowing, and may require personal guarantees from directors of smaller firms.

Because the business handles collections, the provider cannot see directly whether invoices are genuine and whether cash is being banked correctly. The characteristic fraud is the raising of invoices for goods not yet delivered, or for sales that never took place, to draw down more funding. Others are diverting customer payments to another account and failing to report credit notes. Providers respond with periodic audits of the books, verification of a sample of balances with customers, monitoring of the pattern of payments and credit notes, reconciliation of the sales ledger to bank receipts, and the right to disclose the assignment and collect directly if the client defaults.

The legal form varies by country. In some, the debts are purchased outright by assignment; in others the arrangement is a loan secured on the debts. Clauses in a customer contract that prohibit assignment can make an invoice ineligible, though several countries, including the United Kingdom since 2018, have restricted the effect of such clauses for smaller suppliers. In the accounts of the business, invoices financed with recourse generally remain on the balance sheet with the advance shown as borrowing, since the risk of non-payment has not been transferred. The related buyer-led product, in which a large customer arranges early payment for its suppliers, is reverse factoring.