Cheat sheet: Invoice finance discounting and factoring explained

eBook: 101 Guide to small business finance

This exclusive extract from Propell’s soon-to-be released eBook — 101 Guide to small business finance — explores the options of invoice finance discounting and factoring for SMEs. 

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Discounting

Invoice finance discounting is useful for accessing cash from your unpaid invoices without having to wait weeks or months for your customers to pay. This allows you to preserve your working capital and carry on with business without relying on prompt payment from customers.

What is it? 

• A type of business finance that is offered against the value of your accounts receivable ledger (invoices you’re waiting for your customers to pay).
• Secured by the value of your receivables, so no other assets need to be offered as security.
• Invoice finance helps manage cash flow by allowing you to access cash before your outstanding invoices have been paid.

Example:

• You have $30,000 worth of outstanding invoices waiting to be paid by your customers;
• You need to spend $10,000 on supplies for your next job, but you don’t have enough cash available to cover this expense;
• You choose to close this gap in your cash flow by taking out invoice finance against your accounts receivable;
• You are extended credit of $24,000, which is 80% of the value of your unpaid invoices; then
• When your customers pay your invoices, the amount goes into a collections account which repays the outstanding finance. The excess funds are transferred to you, minus any fees or interest.

Benefits: 

• You don’t need to worry about your credit score, because the finance is granted based on the creditworthiness of your customers. If your customers are likely to pay their outstanding invoices, you’re likely to be approved for invoice finance.
• The finance is secured against your outstanding invoices, so you don’t need to offer any other assets — like your family home — as security. 
• You can turn your invoices into cash without waiting for your customers to pay. 
• There are no repayments for you to keep on top of. The finance is repaid as your customers pay their invoices.

Fees

1. Discount rate

   This is similar to how an interest rate on other types of business finance works. It is calculated on the amount of the advanced funds. This fee is calculated daily and charged monthly.

2. Drawdown fee

   When a line of credit is extended to you based on the value of your outstanding invoices, you may be charged a drawdown fee when you choose to drawdown from the invoice finance facility.

3. Advance fee

   Like a drawdown fee, you may be charged an advance fee each time you are offered an advance on an invoice.

4. Administration fee

   A service or admin fee may be charged on each invoice you submit for financing.

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• The amount of finance you may be offered directly depends on the value of your unpaid invoices. You will generally be able to get between 80% to 90% of the invoice value as an advance. This may not be practical for businesses needing higher loan amounts.
• Clients not paying their invoices can impact the terms of your invoice finance. If your customers do not pay their invoices, the invoice finance provider may charge a higher advance fee to cover the costs of missed payments.

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Factoring

Invoice factoring is a type of invoice finance that varies slightly to invoice discounting. With discounting, specific invoices are selected to use as security against the advance or line of credit. With factoring, the lender takes the complete accounts receivable ledger and manages collections of customer payments.

Like with the discounting, as the customers pay their invoices, the lender transfers the excess funds to the borrower, minus any advance fees.

Invoice factoring and discounting are both forms of invoice financing, and both allow the business a cash advance on their outstanding invoices. Invoice discounting is a loan secured against unpaid invoices, whereas with invoice factoring, the lender purchases the unpaid invoices and takes control of the management.

This extract from the eBook was authored by Estelle Fletcher, commissioned by Propell. You can pre-register for the full eBook here.