Invoice Discounting

Who is Invoice Discounting For?

Invoice discounting suits B2B SMEs that have at least six months of trading history and some established customer relationships. Those customers must be creditworthy and not in high-risk industries. Payment terms should typically be over 30 days; otherwise, it’s an unnecessarily expensive form of financing.

Because profit margins may take a hit of up to 5%, it may not be viable for firms operating in high-volume, low-margin sectors. A 5% fee when margins are only 10% is a 50% reduction in profitability.

Industries that commonly use it:

• Manufacturing due to the high cost of bulk raw materials and long production cycles
• Logistics firms to cover fuel costs
• Recruitment agencies to bridge the payroll gaps
• Professional services delivering large projects
• Construction due to long receivables cycles

Invoice Discounting vs. Other Business Finance Options

Business loans are unrestricted capital, meaning they can be obtained at any time and used for a broad range of purposes. While invoice discounting is tied to what customers pay, business loans aren’t restricted to revenue. On the flip side, repayments aren’t tied to when customers pay, meaning you’re responsible for meeting monthly repayments regardless of when they’re made.

Loans require personal guarantees and charge interest from day one. While secured business loans are generally cheaper than invoice discounting, unsecured loans may not be.

For a seasonal business with volatile sales or no tangible assets to secure, a business loan could be either risky or expensive. However, for stable companies with a strong credit score and a solid business plan, a business loan could be the best option for growth.

Invoice discounting vs overdrafts & credit lines

Bank overdrafts and credit lines often have a cap of around £50K-£100K for SMEs, which might be less than your invoice financing ceiling. However, having a credit facility that can be tapped into as needed offers a benefit, as it also targets cash flow pain points.

Overdrafts typically carry an APR of around 15%-20%, making them more expensive than invoice discounting if used regularly. But, for very short-term needs, it can be both more convenient and cheaper than invoice financing. One consideration is that banks can withdraw or change limits on overdrafts overnight.

Invoice discounting vs merchant cash advances

Merchant cash advances are a form of revenue-based finance with future card sales being used as collateral instead of invoices. The merchant cash advance provider takes a small percentage of all future card sales revenue until the loan is paid off. So, like invoice discounting, repayments only occur when you get paid, and interest isn’t accrued in the meantime.

MCAs suit retail and hospitality with high card sales volume. For B2B, invoice financing may make more sense unless the company has high-volume, low-value invoices.

Invoice discounting is a sensible option when seeking a quick boost to working capital, particularly for quality B2B customers with extended payment terms.

Invoice discounting vs business credit cards

Business credit cards are ideal for short-term, flexible spending, such as purchasing supplies or covering operational costs and often offer the benefits of rewards on spending (e.g. cashback, Avois points etc). However, the lending limits will be too low for many firms (typically up to £25K initially for many SMEs), who will be able to borrow far more against their unpaid invoices using invoice discounting.

Business credit cards can be the cheapest short-term lending option if the balance is paid in full and no interest is added. So, credit cards offer convenience and rewards, and invoice discounting provides larger, scalable funding directly linked to sales volume. Many SMEs use both in tandem: credit cards for everyday expenses, and invoice discounting to smooth out cash flow gaps caused by slow-paying clients.

Invoice discounting vs Merchant Cash Advances

How Much Does Invoice Discounting Cost?

Discount rate: This is the primary cost and it can range from 0.5% to 5% of the amount advanced (not the invoice value). This is a flat fee that varies depending on risk and the provider.

What determines the rate? If you’re a new company with low turnover and new customers who are not highly creditworthy, the discount rate is likely to be on the higher side.

Service fees: Some providers charge an additional service fee, whilst others include this in their discount rate. When charged separately, service fees are usually applied once based on the total lending provided, not to each invoice. Service fees typically range from 0.2% to 1%. For selective invoice financing and/or with low-value invoices, a higher service fee might be used to cover the additional administrative burden.

Example cost breakdown

When annual invoices are £100,000 and £80,000 is advanced over the course of the year:

• Discount rate (1% of advance): £800
• Service fee (0.5% of turnover): £400
• Total annual cost: £1,200 (1.2% of turnover)

Bear in mind that this is not the same as being advanced £80,000 upfront for an entire year at an APR of 1.5%. Repayment per invoice is often within 1-3 months or so.

Let’s look beneath these numbers. If there were 12 invoices across this year, that’s a cost of £67 per invoice (1% on each £6,667 advance). If each advance was paid back in 45 days, that’s an actual annual cost of around 8% – or 8.5% with the service fee (unlike a discount rate, the service fee is applied once to turnover).

How to Choose an Invoice Discounting Provider

When selecting a provider, speed of funding will likely play a key role. By the nature of invoice funding, urgent cash flow situations can quickly arise.

The total fees charged by the invoice finance provider are paramount, so make sure you have full transparency of fees. Some firms bundle costs together, while others will itemise the discount rate, service fee, and any other fees charged individually.

When looking through the terms, also consider confidentiality, as this is vital in protecting customer relationships.

Customer service is often neglected, but it becomes crucial when facing payment delays or urgent funding needs.

While it may not be a core consideration, industry expertise and the integrations available can help alleviate administrative friction. Integration with accounting software can help data flow and reduce miscalculations, while being an industry leader and financially stable can increase the likelihood of a long-term partnership.

How to Apply for Invoice Discounting

Eligibility requirements for invoice discounting are straightforward. Businesses must be established in the UK, typically with 6-12 months of trading history and a minimum turnover of around £100,000 (sometimes as high as £250,000).

Most invoice finance lenders will need to assess your sales ledger quality and look at your customers’ creditworthiness, payment history and invoice values. Previous late payments from clients will be deemed high-risk. Debtor ageing reports and customer concentration are also examined.

Real-World Examples & Use Cases

Recruitment Agency with Payroll Gaps

A London-based recruitment firm that specialises in game developer contractors typically has payment terms of 45-60 days. Due to their weekly payment terms for contractors, they face constant cash flow pressure. During the lead-up to game releases, they often turn down lucrative contracts because they cannot cover the associated payroll costs.

The solution

Whole-turnover invoice discounting is implemented to access 85% of their invoice value within 48 hours. With an annual turnover of £800,000, they can access up to £680,000 in working capital when needed.

The outcome

The 1.2% annual cost of almost £10,000 was easily absorbed into their 15% profit margins. Most importantly, they could accept 40% more contracts, earning them an additional £320,000 in revenue. In this case, they have sacrificed some short-term profit margin in favour of more profit in the longer term.

FAQs About Invoice Discounting