Summary: Invoice discounting is a form of debtor finance that provides companies with a revolving line of financing secured by accounts receivable. It’s typically used by midsized companies that want to improve their cash flow.
This article explains how invoice discounting works, its costs, and how it compares to invoice financing. We cover the following information:
- What is invoice discounting?
- How does invoice discounting work?
- Typical rates/costs
- Qualification criteria
1. What is invoice discounting?
Invoice discounting is a form of debtor finance used by midsized companies that need to improve their cash flow. The facility operates as a revolving line of financing secured by accounts receivable.
Debtor finance companies usually allow you to draw up to 80% of your eligible receivables. The line is settled as your customers pay their invoices on their usual terms.
a) Invoice discounting vs. invoice finance
Invoice discounting lines are often compared to invoice financing lines. Both solutions have similarities and offer the same benefits. However, invoice discounting has some significant differences.
i. Structure
Invoice financing lines are typically underwritten and structured as the purchase of accounts receivable. Consequently, they have simpler underwriting criteria.
Invoice discounting lines, on the other hand, are underwritten as loans. This offers greater flexibility. However, invoice discounting lines have stricter qualification requirements and covenants.
ii. Company size
Invoice discounting is only available to profitable companies with a yearly turnover exceeding $4,000,000. Invoice financing, on the other hand, is available to smaller companies.
iii. Notifications
Your customer usually receives a simple notification to change their payment address. This usually enables the line to operate as a non disclosed facility.
Invoice financing lines, on the other hand, utilize the standard Notice of Assignment (NOA) that is also used by invoice finance lines. The NOA discloses the facility to the customer.
iv. Reconciliation
Your company must have an accounts receivable department to manage invoicing and payments. All information must be entered promptly into your accounting system. This allows the debtor finance company to reconcile its systems and process funding requests.
2. How does it work?
Invoice discounting facilities operate like a revolving line financing. Your funding availability is determined by your open invoices, less your current draws and settlement fees.
This available funds amount is dynamic. It changes regularly as new invoices are raised, old invoices are paid, and new funding requests are submitted.
a) Drawing funds
Most debtor finance companies allow you to draw up to 80% of your qualifying accounts receivable. Your company can draw funds from its line by uploading a funding request to the debtor finance company’s portal. The request must be accompanied by a report showing the changes to your accounts receivable since the last funding request. This information allows the debtor finance company to reconcile its accounts and determine availability.
a) Settlement / second instalment
Your clients typically make payments into an account that can be accessed by the debtor finance company. This information allows the debtor finance to track payments and settle invoices. The remaining funds are deposited into your company’s bank account.
3. Typical rates and cost
Your rates and costs are based on the size, complexity, and risk profile of your line. Invoice discounting is a volume-based business, and larger lines have lower costs. However, complex transactions with higher risk profiles will have their rates adjusted accordingly. Read “Debtor financing cost explained” to learn more.
a) Due diligence and establishment
The due diligence expense covers the cost of reviewing your company, examining your accounts receivable, determining the credit of your invoices, creating the legal documents, and setting up the account. It is paid once you sign the finance company’s proposal. The cost varies based on the size and complexity of the transaction.
b) Administration fee
The administration fee, also known as a service fee, is paid whenever invoices are uploaded to the system for a funding request. It covers the cost of managing the invoices.
The fee varies based on the transaction’s size, risk profile, debtor concentration, and other criteria. The following table provides an example of administration costs for two different-sized lines.
| Line Size | Administration Fee (Rate) |
|---|---|
| $200,000 | 1.35% – 1.75% |
| $500,000 | 0.80% – 1.25% |
Note: This table can be scrolled left/right on mobile devices.
c) Interest rate
The interest rate, also known as the discount rate, is an ongoing fee charged on the advanced funds. The cost accrues daily and is based on a reference rate that is adjusted to reflect the transactions size and risk profile. The following table provides an example of possible yearly interest rates for two different-sized lines. Divide the rate by 365 to get the approximate daily rate.
| Line Size | Advance Rate | Base Rate | Add/Subtract | Financing Rate |
|---|---|---|---|---|
| $200,000 | 70% – 85% | 12.85% | -0.5% to 1.5% | 12.35% to 14.35% |
| $500,000 | 70% – 85% | 12.85% | -1.5% to 0% | 11.35% to 12.85% |
Note: This table can be scrolled left/right on mobile devices.
4. Qualification criteria
Invoice discounting lines have simpler qualification criteria than most other solutions. The most important requirement is to have quality invoices from creditworthy customers. Additionally, your company should be profitable and well-managed.
a) Profitable company
Invoice discounting is only provided to companies with a track record of profitability. Companies that are in the process of becoming profitable should consider invoice financing as an alternative.
b) Company size
Invoice discounting is intended for larger companies. Most debtor financing companies only offer this option to businesses that have a yearly turnover exceeding $4,000,000.
c) Creditworthy clients
The transaction relies on the creditworthiness of the invoices you want to finance. Consequently, your clients must have good business credit.
d) Several clients
Most debtor finance companies require that their invoice discounting clients have at least three different customers. This limits the concentration of risk on a single customer/debtor.
e) Established finance department
Your company must have an in-house accounts receivable team to manage raising invoices, client follow-ups, and payment updates. This information is required so that the debtor financing company can reconcile the details and process your funding requests.
f) Invoices not pledged as security
Your invoices are the primary collateral for the transaction. They cannot be pledged as collateral to another provider.
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