Invoice discounting: What it means and where to start

Small businesses often face the challenge of managing cash flow while waiting for clients to pay their invoices. Delayed payments can strain operations, making it difficult to cover expenses or invest in growth. Invoice discounting offers a solution by allowing businesses to access a portion of their receivables quickly, rather than waiting weeks or months for customer payments. This financial tool can provide much-needed liquidity to keep operations running smoothly. 

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In this article, we'll explore the invoice discounting process, its benefits and drawbacks, and alternative financing options to help you determine the best fit for your business needs.

What is invoice discounting?

Invoice discounting is a way to finance your business by using unpaid invoices as collateral. Instead of waiting for clients to pay invoices, a lender will loan a percentage of your expected revenue upfront.

How does the invoice discounting process work?

With invoice discounting, your loan amount only goes up to the value of your unpaid invoices (or accounts receivable). This means you cannot borrow beyond the number of sales you make at any given time. As such, it is not a good option for businesses that need investment before attracting clients.

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The exact steps will vary based on which lender you choose to work with, but the general timeline goes something like this:

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1. Apply for invoice discounting: This will require financial information such as your annual revenue and business credit score. Many lenders require a minimum credit score of 500, but some will skip your credit score altogether and look at the creditworthiness of your customers. Almost all lenders will require an average of 5-figure revenue, so if your business hasn’t surpassed the $10,000 mark, this type of funding might not be available.
2. Receive terms from the lender: Depending on your situation and which lending partner you choose, you will see a range of terms. Check how quickly payouts will be received, what percentage of the invoice you will receive, how long you have to pay back the loan, and if there are any service fees.
3. Submit unpaid invoices to the lender: When you have an invoice that you would like to be paid early, submit it to the lender. Depending on your agreement, you are not required to submit every invoice to the lender.
4. The lender will send a percentage of the invoice: The time frame depends on the lender and the loan amount, but typically runs 5-10 business days. It should always be in less time than the customer is expected to pay the invoice.
5. When your customer pays you, you pay the lender. You are responsible for chasing down the outstanding invoice to ensure payment. Because this is a loan, you may incur late fees if you are not able to repay it in a timely manner.

Pros and cons of invoice discounting

Like all forms of debt, invoice discounting has pros and cons. Deciding whether to pursue this type of financing depends on the nature of your business, its financial situation, and your personal preference as a business owner.

Pros

• No collateral: A unique advantage of this type of loan is that you don’t need to put down collateral. Other loans require assets like property, equity or other investments in order to qualify. With invoice discounting, your unpaid invoices act as collateral.
• Better cash flow: Like most loans, invoice discounting increases your cash flow. This gives you cash on hand to pay for operational costs or invest in your business.
• Short-term loan: Unlike other loans, invoice discounting is very short term. There are no 5-year (or even 1-year) agreements. Instead of charging an APY, your lender will take a percentage of the invoice amount.

Cons

• Lower profit margins: Invoice discounting eats at profit margins because of the relatively high percentage that lenders take from the invoice amount. It’s up to you as a business owner to answer the question: do I want 80-90% of my revenue immediately or 100% of my revenue when my customer pays the invoice?
• Higher cost: This type of loan costs more than most other loans in terms of percentages. Whereas you might see small business loans with APYs of 3-7%, invoice discounting often takes 10-15% or more of the invoice total. There may also be service fees or late fees involved.
• Potential for over-reliance: While the short-term nature of invoice financing can be a plus, it may also cause your business to feel like a hamster wheel. This is especially true if you get every invoice paid early by the lender and then chase clients in order to repay the loan in time.

When is invoice factoring a good idea?

Invoice factoring is a good idea when a business needs immediate cash flow to manage day-to-day operations, fund growth, or cover unexpected expenses, but has outstanding invoices with long payment terms. It’s particularly beneficial for companies with a strong sales volume but limited working capital, such as small or growing businesses that may not have access to traditional loans or credit lines. Invoice factoring is also useful for businesses dealing with slow-paying customers, as it allows them to convert accounts receivable into cash without waiting for payment.

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Additionally, invoice factoring can be a strategic choice when a business wants to avoid taking on additional debt. Since factoring is not a loan, it doesn't increase the company's liabilities, making it an attractive option for those looking to maintain a healthier balance sheet. However, it’s important to consider the cost of factoring, as the fees can add up, and ensure that the benefits of immediate cash outweigh the expense. Overall, invoice factoring is a good option when quick access to cash is more valuable than waiting for full invoice payment.

Alternatives to invoice discounting

• Invoice factoring: Unlike invoice discounting, invoice factoring is not a debt. Instead, you sell your unpaid invoices to another company, and they take responsibility for collecting that debt. This must be disclosed to customers because they will pay the company that bought the invoice.
• Reverse invoice factoring: Reverse invoice factoring is also a way to increase cash flow, but it works in the opposite direction as invoice factoring. Instead of selling your client invoices, you ask a lender to pay your supplier invoices. They pay your supplier quickly in exchange for a discount and then you pay the full amount to the lender at a later date.
• Bill discounting: Bill discounting works similarly to invoice discounting, but the loan amount is set against “bills of exchange” rather than invoices. The most impactful difference is that bill discounting works for bills due in 30 to 120 days, whereas invoice discounting usually has a limit of 90 days.
• Term loans: Term loans provide a lump sum of money that you repay over a fixed period with interest. Unlike invoice discounting, term loans are not tied to specific invoices or accounts receivable. They are often used for larger, long-term investments and require a set repayment schedule.
• Credit line: Lines of credit offer flexible access to funds up to a specific limit, allowing you to borrow as needed and only pay interest on the amount you use. Unlike invoice discounting, a line of credit is not tied to specific invoices and can be used for various business needs, offering more flexibility in managing cash flow.

‍Examples of invoice discounting

1. A small manufacturing company produces and ships custom furniture to a retailer. The retailer is given 60 days to pay the invoice, but the manufacturer needs cash immediately to purchase materials for the next order. The manufacturer sells the unpaid invoice to a factoring company, receiving 85% of the invoice value upfront. The factoring company then takes on the responsibility of collecting payment from the retailer. Once the retailer pays, the factoring company gives the remaining 15% to the manufacturer, minus a small fee for the service.
2. A digital marketing agency completes a large project for a client and issues an invoice with 90-day payment terms. To improve cash flow, the agency sells the invoice to a factoring company. The factoring company advances 80% of the invoice amount immediately, allowing the agency to cover operational expenses. The factoring company collects payment from the client at the end of the 90 days. After receiving the payment, the factoring company sends the remaining 20% to the agency, deducting their service fee.

Optimize your finances with Ramp

If invoice discounting is not for you or if you want options in addition to invoice discounting, Ramp is here to help.

Commerce sales-based underwriting

Ramp’s commerce sales-based underwriting method gives you access to working capital without jumping through the hoops of traditional underwriting. Instead of looking at cash on hand or years in operation as a sign of business health, we let your revenue speak for you.

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Instead of asking you to chase down documentation, our platform lets you easily connect to Stripe, Shopify, Amazon and other platforms where you’re already conducting your business. With as little as one year of data, we’re able to approve you for a higher credit limit.

Expense management

Whether you need to manage capital from a loan or want to optimize your current spending before applying for one, Ramp’s expense management system helps you gain visibility into your business finances.

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With Ramp, finance automation does much more than pay your bills on time. When you automate invoice processing and spend with Ramp, you’ll immediately be able to place spending controls by category, access dashboards and get AI-powered alerts for saving opportunities.

Building credit

Credit is often the biggest barrier to securing traditional loans. Not only does Ramp help you access business credit sooner through innovative underwriting techniques, but the built-in expense management system keeps you on top of your payments and helps you build your credit even further. As an added bonus, you’ll save an average of 5% on purchases made using your Ramp card.

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When you’re ready to apply for other types of funding, you’ll be confident in your finances—and so will your lender. Learn more about Ramp today.

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