Invoice discounting: How to Avoid the Top 4 Risks
With great financial flexibility and faster cash flow on offer, is it any wonder invoice discounting is booming for businesses large and small? With the ability to revolutionize supply chains, it can be a real game-changer. But there are some invoice discounting risks to be aware of, before jumping in and funding your first invoice.
Successfully using invoice discounting as a funding strategy for your business comes down to having a firm grasp of what invoice discounting is and understanding the hidden risk well in advance. Here’s how to avoid some common invoice discounting risks.
What Is Invoice Discounting and How Does It Work?
Invoice discounting is when an invoice discounting company takes a percentage of an outstanding invoice in exchange for paying you the remainder upfront. This allows you to avoid waiting weeks or months before you receive your invoice payments from your clients. Invoice discounting is also known as invoice financing, accounts receivable financing and deferred payment financing.
Factoring is a term used when a company sells its future revenue streams (such as unpaid invoices) to another party. Companies like to factor or discount invoices because it gives them access to cash quickly, offering them a fast and flexible way to finance purchases.
For example, if your company sells $100,000 worth of product, but your customer wants to pay the invoice on net terms – 60 days from now – you have the ability to get paid immediately with invoice discounting, instead of waiting two months from now. Keep in mind that invoice discounting carries risks, just like many other funding sources.
Difference Between Invoice Discounting and Invoice Factoring
Invoice discounting and invoice factoring are similar in a lot of ways, but there are some differences between them. First, they are both methods of invoice financing. While invoice factoring is suitable for both new and established businesses, invoice discounting is generally chosen by established businesses.
- With invoice factoring, a business sells their outstanding invoices to a factoring company for a percentage of the face value. The factoring company then takes responsibility for collecting payment from the customer.
- With invoice discounting, businesses sell their outstanding invoices to a funding company. The funding company provides a cash advance based on a percentage of the invoice’s value, and pays the remaining balance after the business’ customer pays the invoice.
- When you factor an invoice, your customer is aware as they must work with the factoring company to arrange payment. However, with invoice discounting, your customer is not aware that you’ve discounted the invoice.
In both cases the funding company takes a percentage of the invoice value as a fee – usually anywhere from 2.5-10%, depending on the company. (Hidden fees are just one common invoice discounting risk to be aware of.) Both invoice discounting and invoice factoring help improve cash flow and increase a business’ access to working capital.
Advantages of Invoice Discounting
When used correctly, invoice discounting can be a valuable tool for managing your business’ cash flow. Some advantages of invoice discounting include:
- Freeing up cash flow to may payroll, purchase supplies, or take on a growth project.
- Helps reduce seasonal strain and any cash flow gaps.
- Helps reduce slow receivables.
- Gives you more cash on hand.
- Allows your business to grow without debt or equity.
- Provides funding within days – much faster than traditional bank financing options.
- Boosts access to cash in case of an unforeseen emergency.
- Funding grows with your business. The more you invoice, the more funding you can access.
- Avoid big bank financing hassles.
Invoice discounting allows you to leverage the credit quality of your customers, while also giving you access to capital that you may not otherwise have access to as a startup or a small business. You can discount invoices both for domestic and international sales. This funding works best where:
- Your customer is a large company with strong financials.
- You have regular transactions so lenders can see what your payment cycles look like.
Disadvantages of Invoice Discounting
The promises of flexibility and cash flow are definitely real, but as with other forms of accounts receivable financing, starting to use new financial tools without knowing the dangers is a recipe for disaster. Here are some common invoice discounting risks.
Invoice Discounting Risk #1: Misunderstanding Invoice Discounting
A lot of people misunderstand what invoice discounting is, and what’s involved. Many people get it confused with invoice factoring. As explained above, there are plenty of differences between invoice discounting and invoice factoring. In an ideal world, your customers would pay you as soon as you invoice them, but in reality, few customers are able to pay instantly. Invoice discounting gives you fast access to money for work you’ve already invoiced for, unblocking cash flow to help you meet the demands of growing a small business.
Once you’re through the application process, your business will have access to working capital if and when needed. With FundThrough specifically, there’s no minimum to fund and you only pay a fee when you fund. Once you have an approved credit limit, you can begin discounting invoices up to that maximum. In some cases, the funding company will specify which customers’ invoices can be funded, based on their creditworthiness.
Invoice Discounting Risk #2: Negative Perceptions
There are some people out there who think that invoice discounting will give a negative impression of your business and that you aren’t financially responsible or that your business is in trouble, but that couldn’t be further from the truth.
Many small businesses and startups take advantage of invoice discounting for quick and convenient access to growth capital, especially with banking regulations and requirements that are becoming more and more stringent every day. Many companies simply use invoice discounting as a healthy cash flow option to help increase revenues and cover expenses.
In fact, chances are that if you’re working with other large suppliers and businesses, they’re already familiar with invoice discounting and invoice factoring. Many household brands also use invoice discounting and factoring (on both sides of the B2B transaction) to cover their own cash flow gaps and as suppliers to other SMBs.
Invoice Discounting Risk #3: Low Advance Rate and Hidden Fees
Many people assume invoice discounting and invoice factoring have extremely high costs, but the truth is that funding costs have been on a steady decline for a number of years. In addition, as more and more funding companies offer their services, costs remain competitive as they compete for customers. Finally, as the funding marketplace continues to become more efficient, prices will remain competitive.
When looking at whether or not invoice discounting is right for your unpaid invoices, it’s also important to look out for hidden costs. Some invoice discounting and factoring companies will bring in clients with low ‘teaser’ advance rates, which leave out other hidden fees.
These costs may include monthly minimums, administrative fees, application fees, proposal fees, due diligence fees, credit checking fees, notification fees, schedule processing fees, etc. They may be hidden in the fine print of your contract, so read carefully before signing.
You also want to be able to trust your invoice discounting company to be an honest and transparent partner. Companies which are upfront about the costs and benefits for your specific situation might be your best bet.
This is why doing your research is key to understanding overall total costs, and that you’re working with the best invoice factoring company. At FundThrough, our AI-driven technology allows us to offer highly competitive invoice discounting and factoring rates.
Invoice Discounting Risk #4: Over-Reliance
Monitoring your accounts receivable is key to getting the most out of invoice discounting, so you aren’t relying too much on invoice discounting for your everyday finances or relying too much on a single client. While having a line of credit is a great way to improve your cash flow, you can’t build your business on the assumption that this option will be available 100% of the time.
Flexibility is indeed one of the core benefits of invoice discounting and other capital finance tools. A lot of companies will use invoice discounting as a type of bridge loan. The irony here is that if you make these tools an assumed core part of your finances, then you lose their unique flexibility.
The key is to stay agile and prepare for contingencies. Always ask yourself if invoice discounting or factoring is right for a particular moment and a particular item in your accounts receivable.
Ready to Get Started With Invoice Discounting?
If you have a solid understanding of the discounting process and all of the invoice discounting risks listed above, you’ll be in a great position to take advantage of the full power this financial tool has to offer.
At FundThrough, we help small business owners navigate cash flow hurdles every day. If you’re interested in learning more about invoice discounting and factoring, our Complete Guide to Invoice Factoring is chock full of information, and answers 45+ questions you might have about the process.
If you’re ready to get started with invoice discounting in Canada and the United States, FundThrough can help. See if you qualify for our invoice funding solution.