Invoice discounting: the pitfalls

Invoice discounting is being considered by a business woman

Invoice discounting: the pitfalls

Invoice discounting can seem like an ideal solution if you are facing cash flow issues in your business.

If you have not heard the term before, let me explain what it is. You effectively ‘sell’ unpaid invoices to a lender so they give you a cash advance that is a percentage of the invoice’s value.

Once your customer pays the invoice, the lender pays you the remaining balance minus their fee. You continue to chase the invoices and, usually, your clients do not know that you are using invoice discounting. As well as invoice discounting there is invoice factoring, which works differently.

Pitfalls of invoice discounting

Throughout my career, I have utilised the funds offered by invoice discounters or factors to finance the business’s working capital.

It has not always been easy! Here are 3 reasons you should work with me when considering this form of finance for your business.

1. Headline prepayment percentage is nothing like the effective prepayment percentage

All brokers and providers of this type of finance say they will advance 75% to 90% of your invoice value. They will try and do this initially. But after taking all of the covenants into account you rarely receive this percentage of the invoice value you submit. Covenants, such as late payment by client and concentration issues, can reduce the effective prepayment substantially.

These types of lenders want to make money from what you borrow with as little risk as they can engineer. So, if you have overdue invoices outside the agreed credit terms, they will be reserved out of the money available from which you borrow.

This effectively means the invoices being put into them are going against the reserves rather than introducing new invoices on which you can borrow.

Similarly, concentration is used frequently by invoice discounters as a way of limiting their exposure to potential bad debt risk. If your customer’s ledger balance is higher than an agreed percentage of the total ledger balance, they will again make a reserve of the difference to reduce the availability that you can borrow.

2. Loss of sales won’t mean a reduction in your monthly fees.

When you set up a facility, the fees are based on estimated turnover and subject to a minimum monthly fee. You pay this even if you do not achieve the anticipated turnover. Considering what affects your ability to achieve your turnover forecast, having a fixed fee is almost like your invoice discounter is imposing a penalty!

They do not lose out on their fees as you still have to pay them from the falling number of invoice values submitted.

You need only think about how the Covid-19 virus has impacted on almost all turnover for businesses. You can be assured that finance providers do not see their fixed revenue fall.

3. They don’t trust you.

As the lenders provide finance on sales invoices the potential for fraud is huge. If you hit a bad time, what stops you from submitting invoices that are not genuine to release badly needed funds? Invoice discounting and factoring companies are aware of this temptation and employ various techniques to counter it. As a result, the may:

  • Call your debtor verifying the invoice is owed.
  • Demand sight of the invoice and the back up including signed delivery notes and sales orders.
  • Inevitably conduct an audit either physically or digitally so that they can assure themselves that you are operating the account as it should be and in accordance with the agreement.

I am in no way advocating you should commit fraud, but be aware of the intrusion into your business that using these funders can bring! And that’s even if there is nothing suspicious about your business and your transaction with the lender.

I am not saying this form of finance is unsuitable for all businesses, by the way! But if you want to proceed down this now mainstream source of borrowing then you need the best advice you can get. Review all available options, negotiate with providers and ensure lending requirements are met. Do not fall foul of the many covenants in the agreement inadvertently.

That is why the team at Guidon Group acts in your best interests, as we have no affiliations with lenders or brokers and receive no commission from them. All and any savings we make are passed directly to you, the client.

So if you are considering this form of financing call us now for a no-obligation discussion as to the best form of borrowing for you.