Invoice Discount: What Is It & How Does It Work? [w/ Example]

An invoice discount is a financial service that enables business owners or vendors to access the necessary funds with the help of their unpaid invoices in advance.

This practice represents a method thanks to which business owners can maintain cash flow for their operations without waiting for customers to pay their outstanding invoices in full.

If you’re new to the concept of invoice discounting, this article will explain how it works, as well as what its advantages and drawbacks are. Let’s start!

Key Takeaways

• By qualifying for an invoice discount, business owners or vendors can borrow cash in the value of their unpaid invoices from invoicing companies.
• The main distinction between invoice factoring and invoice discounting is that the former requires vendors to sell their invoices to a factoring company. Meanwhile, the latter involves borrowing against the vendor’s accounts receivable account.
• Qualifying for an invoice discount requires business owners to have a good credit history and be consistent in collecting invoice payments to avoid accumulating penalties and fees on top of their loan amount.

What Is Invoice Discounting?

An invoice discount (or invoice financing) is a type of business financing wherein vendors raise their unpaid invoices to a third-party financier or a company offering invoice discounting services.

When using an invoice discounting service, vendors or business owners borrow money against their accounts receivable to secure cash advances. The finance provider deposits the funds into the vendor’s account; once they are paid by customers, vendors use the money they receive to repay what they borrowed from the financier.

Some examples of businesses that rely on an invoice discount to manage their finances include pharmaceutical companies, manufacturers, and suppliers of fast-moving consumer goods (FMCG).

How Does Invoice Discounting Work: 6 Key Steps Explained

In a nutshell, invoice discounting works similarly to a short-term loan, albeit more flexible and manageable for suppliers and small business owners. Below are the specific steps in processing an invoice discount service:

#1. Selling Goods and Sending the Invoice

Before a vendor or supplier can secure an invoice discount, they must first sell their goods to a customer—they cannot send or issue invoices unless a purchase is made.

The invoices issued by the supplier to their customer often follow a deferred payment term, which means that the customer can pay the total amount due at a later due date. A deferred payment on an invoice also allows customers to settle their invoices in installments.

#3. Vendor Raises the Unpaid Invoice

To get an invoice discount, the vendor submits a copy of their unpaid invoice(s) to a third-party financier or a company specializing in handling invoice discounts.

From a financier or invoice discounting company’s perspective, these invoices will serve as collateral or a guarantee for the amount the seller wishes to loan.

#4. The Financier Evaluates the Validity of the Invoice

Upon receiving the invoices from the supplier, the financier evaluates the validity and legality of the invoices. They will go through the details, mainly the invoice payment terms, the net amount to be paid by the customer, and the invoice due date.

Reviewing these also allows invoice discounting companies to assess the value of the unpaid invoice. They then use a specific formula to determine the amount they can lend to the business owner.

The invoice discounting formula usually includes the invoice value and the prepayment percentage. The latter is an estimated percentage of the invoice value that the vendor may be willing to repay in advance. Finance providers will also factor in the fees to cover interests and protect the financier or their business from potential risks.

#5. Customer Settles Their Balance

While customers are expected to settle their balance or unpaid invoices on or before the set due date, sellers are expected to follow up on their customers’ outstanding payments.

Whether it entails sending email reminders and invoice due notices or going after late payers, vendors must be strict and assertive in enforcing their late fee policies. If not, they may face possible penalties and higher repayment fees.

Aside from establishing clear late fee policies and consistently following up on customer payments, vendors can also create invoices that are short and to the point. In this manner, customers can understand the vendor’s terms and conditions more easily.

An easy way to achieve this is through using Paystub.org’s invoice generator. With ready-made templates and a built-in calculator, our generator lets business owners issue and monitor customer invoices more efficiently. This means that, in the long run, vendors establish a more seamless invoicing process for every transaction.

#6. Vendor Repays the Financier

After securing the entire invoice payment from their customers, vendors must repay the borrowed amount to the financier or invoice discounting company.

Aside from the loan amount, a supplier or vendor is also required to pay an additional 1% to 3% fee, which financiers use for risk protection and cost-regulating purposes.

Invoice Discounting Example

Here is a simple invoice discounting example that will show you how this process goes:

Let’s say Mr. Marks owns a company that supplies materials to pharmaceutical companies.

He recently sold $10,000 worth of supplies to ABC Pharmaceutics and issued an invoice granting the client 120 days to pay the total amount. Since the amount to be repaid is quite a big one, Mr. Marks seeks to qualify for an invoice discount.

He then heads to a reputable company that offers invoice discount services and submits copies of the unpaid invoices he issued to ABC Pharmaceuticals.

Consequently, the invoice discounting company assesses his eligibility and invoices and offers a 70% prepayment percentage.

Upon agreeing to the set prepayment rate and additional fees set by the invoice discounting company, Mr. Marks receives an advance payment of $7,000 for his invoices.

Once ABC Pharmaceuticals fully pays for the materials provided, Mr. Marks will repay the amount he was given by the invoice discount provider.

Invoice Discounting vs. Invoice Factoring: Key Difference

The main difference between invoice discounting vs. factoring is that the former is a loan that allows sellers to maintain control over their accounts receivable.

Meanwhile, the latter is not a type of loan; it surrenders control over a vendor’s accounts receivable to an invoice factoring company.

Vendors who secure an invoice discount borrow money against their accounts receivable. But, in an invoice factoring arrangement, the vendor sells their accounts receivable or invoices to an invoice factoring company at discounted rates.

The table below summarizes more of the critical differences between invoice discounting and invoice factoring:

Advantages & Disadvantages of Invoice Discounting

The invoice discounting advantages and disadvantages described in this section are meant to help you better assess whether an invoice discount suits your business structure.

3 Biggest Invoice Discounting Advantages

The main advantage of qualifying for an invoice discount is that it allows you to secure funds quickly so your business can operate continuously without worrying about financial hurdles.

After all, it can be challenging to acquire supplies for your products and improve manpower for your services without a consistent cash flow.

Other essential advantages of invoice discounting include:

• Simplified loan and repayment terms. An invoice discount entails a simple and straightforward process that startups and vendors can easily follow. All they have to do is ensure they have a good credit history and can repay the borrowed amount.

• Excellent credit management. The qualifications for an invoice discount push vendors to maintain a good credit history. Also, aside from the fact that invoice discounting has relatively affordable fees, it rarely leads to an accumulation of debt for as long as the vendor consistently follows up on customer payments.

3 Notable Invoice Discounting Disadvantages

The biggest disadvantage of invoice discounting is that vendors may face a more considerable financial burden if they are not assertive enough in collecting their customers’ unpaid invoices.

Unlike invoice factoring, which takes the heavy lifting of collecting payments from the sellers, invoice discounting retains the said responsibility with the vendors. Therefore, it can be tedious to monitor all repayments simultaneously if they are dealing with multiple invoices.

Some disadvantages worth considering also include:

• Habitual loans. Although repaying invoice discount fees is generally manageable, it may not always be the case for vendors who tend to become overly reliant on invoice discounting. Given its convenient and seamless structure, sellers may rely too much on an invoice discount’s easy access to fast cash and even be trapped in a cycle of debt.

• Fees and liabilities. Financiers and invoice discounting companies charge different fees in exchange for their services. The number of fees can vary depending on the finance provider. Moreover, sellers become liable for their customers’ unpaid invoices and late payments.

Final Thoughts

Acquiring an invoice discount benefits small business owners and vendors who want financial security while running and maintaining their businesses.

It is important to note that while it may be more convenient to use invoice discounting to balance your business expenses, you must also ensure you meet the essential criteria to qualify for one.

That means you must have a good credit history, be ready to pay the additional fees coupled with your invoice discount, and have a foolproof action plan for collecting invoice payments.

Invoice Discount FAQ

#1. What is confidential invoice discounting?

Confidential invoice discounting (CID) is a more elaborate term used to describe the nature of acquiring an invoice discount.

In truth, invoice discounting is a confidential transaction. The reason is that customers are unaware that their repayment plays a crucial role in helping vendors repay money loaned from financiers.

#2. How do I create an invoice discount?

Technically, you cannot create an invoice discount if you are the seller looking to qualify for one. Instead, you can submit copies of your customer’s unpaid invoices to a finance provider, who will determine the amount you can advance or borrow.

#3. What is selective invoice discounting?

Selective invoice discounting is a type of financing method wherein vendors or business owners can get cash from unpaid customer invoices on a per-invoice arrangement.