Invoice Discounting: Understanding the 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 game-changer.
However, if not used properly, invoice discounting has the potential to do just the opposite. Being successful comes down to having a firm grasp of what invoice discounting is and understanding the hidden dangers well in advance.
Here’s everything you’ll need to know.
Invoice Discounting 101
What is invoice discounting most generally? It’s 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.
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 the biggest dangers from invoice discounting and how you can avoid them.
Danger #1: Being Denied Invoice Discounting Because of Debtor's Credit
As a business owner, you’re used to keeping close track of your personal credit, but you may not be paying close enough attention to the credit of your client companies and individuals.
For invoice discounting companies, the credit of your debtors is everything. If a major client of yours encounters financial difficulties and their credit-worthiness takes a hit, it can result in their invoices being disqualified for discounting. If you were relying on that faster cash-flow, this can be disastrous.
The best way to prevent finding yourself in a jam is to avoid over-reliance.
Danger #2: Getting Caught in a Cycle of Over-Reliance
Monitoring your accounts receivable is key to getting the most out of invoice discounting.
This applies both to relying too much on invoice discounting for your everyday finances and relying too much on a single client. While having a line of credit from your outstanding invoices 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 (read what is factoring). A lot of companies will use invoice factoring as a 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.
Danger #3: Using Invoice Discounting Without Diversity in your Accounts Receivable
Relying too much on a single client is a separate problem. Invoice discounting works best when you have a variety of unpaid invoices from a variety of debtors.
This is in part because of concentration levels, where invoice financing companies put a limit on how much of your total sales ledger can originate from a single debtor. A typical concentration level might be, say, 20%. For example, if your total accounts receivable is, say, $65K, you can’t use invoice discounting with any single line worth more than $13K.
It also makes you more vulnerable to problems arising from credit problems. You never want to put your business in a situation where it could fail if you’re unable to use invoice discounting with a single debtor.
All of this means that if your business works with only a single large client or two, invoice discounting may not be the best financial solution. Bear in mind, you do still have options if a debtor defaults.
Danger #4: Getting hit with Hidden Costs from your Invoice Discounting Company
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’ rates which leave out other costs.
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.
Making the Right Choice
If you have a solid understanding of the discounting process and all of the dangers listed above, you’ll be in a great position to take advantage of the full power this financial tool has to offer.