Guide to Invoice Discounting

Many small businesses are turning to invoice discounting when they are in need of some quick cash. The truth is that not having cash is the probably the number one reason that most small businesses fail. The information below is intended to be a guide on the subject and hopefully answer a lot of frequently asked questions.

First of all it would be helpful to have a definition. It is usually easiest to understand by comparing invoice factoring and invoice discounting. Both of these deal with a company’s accounts receivable or invoices.

Factoring Invoice Discounting

Factoring consists of a company selling its accounts receivable to a third party factor. The third party is completely in control of these receivables from the moment of sale. When the factor buys the receivables it usually pays around 80% for them. Then when the factor collects the money from the invoices, it usually remits the rest of the payment minus the factor’s fee. This fee is usually around 2%-4% per invoice per month. Not a bad deal for a company in dire need of cash.

Factoring Invoice Discounting

With the discounting method a company is still using its receivables as leverage, but in a slightly different manner. Here the company does not sell its invoices to a third party factor, but instead it uses its receivables to try and get a loan from an invoice discounting company. However as opposed to actually selling the invoices to a factoring company, the company never relinquishes control of its invoices.

Costs of Discounting Invoice

When dealing with discounting receivables, there are two costs that arise. First a company pays interest because this is a loan (as opposed to factoring where it is a sale). The interest rate is usually around 1-3% over the risk free rate. The second cost is the fee that a company pays for the invoice discounting services. This rate is usually less than the amount paid for factoring because when discounting a company still has to collect their own receivables; with factoring the factor collects the receivables. The rate is usually around .5% of turnover.

Pros and Cons

With factoring a company no longer has to worry about collecting the receivables (that is now up to the factor). This means that a company can get completely rid of the collections staff if they factored everything.

However, on the flip side this means that someone who may not care as much about customer relations will be collecting; this could hinder repeat purchases. This very disadvantage led to confidential invoice discounting (basically a company sells its receivables to a factor, but it is still up to the company, not the factor, to collect). With this confidentiality a company can maintain good standing with its customers.

A company may also want to consider the information it loses by selling its receivables. It can be valuable knowledge to know which type of customer pays quickly or which type of customer pays at all. The factoring company may not provide as much information in which case a company should probably choose to be the collector.

As mentioned above, the cost of factoring receivables is more than invoicing them. In other words, under the discounting method a company will receive more overall cash than under the factoring method. This makes sense because the factor has to do a lot more work than a bank which simply loans the money.

Summary: If a company is in need of quick cash then factoring and discounting receivables are two available options. Factoring is when a company sells its receivables; discounting is when a company uses its receivables to get a loan. Factoring costs more than discounting, but it also provides the collection services.