Invoice discounting is a form of short-term borrowing often used to improve a company's working capital

Working capital

Working capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is...

 and cash flow

Cash flow

Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...

 position.

Invoice discounting allows a business to draw money against its sales invoices before the customer has actually paid. To do this, the business borrows a percentage of the value of its sales ledger from a finance company, effectively using the unpaid sales invoices as collateral

Collateral (finance)

In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...

 for the borrowing.

Although the end result is the same as for debt factoring

Factoring (finance)

Factoring is a financial transaction whereby a business job sells its accounts receivable to a third party at a discount...

 (the business gets cash from its sales invoices earlier than it otherwise would) the financial arrangement is somewhat different.

Features

When a business enters into an invoice discounting arrangement, the finance company will allow the business to draw down a percentage of the outstanding sales invoices - usually in the region of 80%. As customers pay their invoices, and new sales invoices are raised, the amount available to be advanced will change so that the maximum drawdown remains at 80% of the sales ledger.

The finance company will charge a monthly fee for the service, and interest on the amount borrowed against sales invoices. In addition, the finance company may refuse to lend against some invoices, for example if it believes the customer is a credit risk, sales to overseas companies, sales with very long credit terms, or very small value invoices.
The lender will require a floating charge

Floating charge

A floating charge is a security interest over a fund of changing assets of a company or a limited liability partnership , which 'floats' or 'hovers' until conversion into a fixed charge, at which point the charge attaches to specific assets...

 over the book debts (trade debtors) of the business as security for the funds it lends to the business under the invoice discounting arrangement.

Responsibility for raising sales invoices and for credit control stays with the business, and the finance company will often require regular reports on the sales ledger and the credit control process.

Invoice discounting is targeted at larger companies with established systems and an expected annual sales turnover in excess of £500,000; providers will need to be satisfied that the client can manage their own sales ledger administration and credit control facilities.

Benefits

• By receiving cash as soon as a sales invoice is raised, the business will find that its cash flow and working capital position is improved.
• The business will only pay interest on the funds that it borrows, in a similar way to an overdraft
  Overdraft
  An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. In this situation the account is said to be "overdrawn". If there is a prior agreement with the account provider for an overdraft, and the amount overdrawn is within the authorized overdraft...
  
  , which makes it more flexible than debt factoring.
• Invoice financing can be arranged confidentially, so that customers and suppliers are unaware that the business is borrowing against sales invoices before payment is received.

Drawbacks

• In some industries, financing debts can be associated with a company that is in financial distress. This can result in suppliers becoming reluctant to offer credit terms, which will reverse many of the benefits of the arrangement.
• Invoice discounting is an expensive form of financing compared to an overdraft or bank loan.
• As the finance company takes a legal charge over the sales ledger, the business has fewer assets available to use as collateral for other forms of lending - this may make taking out other loans more expensive or difficult.
• Once a business enters into an invoice discounting arrangement, it can be difficult to leave as the business becomes reliant on the improved cash flow.