As with any type of financial product the involve risks, we look at the risks that are associated with invoice discounting. Due to discounting being a lesser known finance product, it’s always worth being fully armed with the facts before considering them as an option.
Not all types of funding solutions are always equal, and there can be significant cost differences. With loans and similar finance solutions, there can be the risk of unpayable debts and increasing charges. But what about invoice discounting, what are the risks associated with this non-traditional type of lending? Is it a risk-free choice, or are there issues to be aware of?
There are certainly a few things that you’ll need to bear in mind as the client. These will also depend heavily on your agreement in particular, which is why it’s essential to fully understand what sort of contract you’re signing up to. This will also help you compare finance products from different providers.
Understanding the risks
Many businesses use invoice discounting as a way to improve their cash flow, but there are some risks associated with this type of funding. One of the biggest risks is that the business could become overextended if invoices are not paid on time.
This could lead to the business having to pay back the loan with interest, which could put the business in a difficult financial position. Another risk is that the business could default on the loan, which would damage its credit rating and make it difficult to obtain funding in the future.
Finally, invoice discounting is a form of short-term financing, which means that it can be expensive if the business needs to extend the loan for an extended period of time.
For these reasons, it is important for businesses to carefully consider the risks and benefits of invoice discounting before entering into this type of agreement.
When making a comparison you should always compare like for like wherever you can, as well as having a clear and transparent view on the risks that are associated with discounting.
We take a look at a number of risks that are connected with this type of finance.
Reliance on invoice discounting for cash flow
The reliance on an invoice finance type product is one of the risks, particularly if costs increase. Invoice discounting doesn’t have to be a permanent solution, and does of course have an ongoing cost associated with it.
Should your customers pay late repeatedly, or you’re in an industry in which invoices are well known for having long delays, then you might find that factoring costs are higher, or increase at a later date. You must ensure that the fees associated with your facility are sustainable.
Customer relationships
As invoice discounting is confidential a new bank account needs to be established, this client account is only used for receiving payments from your customers.
Customers sometimes get worried when a new banking facility is being used and worry about the businesses stability.
Relying too much on a single client
Relying too much on a single client is a separate problem. Invoice discounting works best when you have a variety of unpaid invoices from a variety of debtors.
This is in part because of concentration levels, discounters will place a limit on how much of your total sales ledger can originate from a single debtor.
A typical concentration level might be, say, 30%. Example, if your total accounts receivable is, say, £70K, you can’t use invoice discounting with any single line worth more than £21K.
This situation also makes the business more vulnerable to problems arising from credit problems. You never want to put your business in a situation where it could fail if you’re unable to use invoice discounting with a single debtor.
This means that if your business only has a single large client or two, invoice discounting may not be the best financial solution.
Excessively late or unpaid invoices
The invoice discounting provider will release the cash of the invoice up to 90% of the value. Once your customer has settled their invoice in full, your provider will then release the remaining 10% or the final percentage amount. If your customer is very delayed in paying your invoice, the final amount won’t be released for some time, until your customer pays in full.
Don’t worry though, as your provider’s expert credit controllers will be dedicating their time to chasing these unsettled invoices. Credit insurance and invoice discounting are complementary financial tools that businesses can utilise to manage risks associated with accounts receivable.
Credit insurance provides protection against the risk of non-payment by customers, while invoice discounting allows businesses to access immediate cash flow by selling their invoices to a third-party, typically a financial institution, at a discounted rate.
Denied Invoice Discounting due to poor Debtor’s Credit
Business owner tend to keep a close eye on their own personal credit, but you may not be paying close enough attention to the credit of your client companies and individuals who they trade with.
For invoice discounting companies, the credit of your debtors is paramount. If one of you major customers encounters financial difficulties and their credit-worthiness takes a hit, it can result in their invoices being disqualified for discounting. If you were relying on that faster cash-flow, this can be disastrous.
To prevent finding yourself in a jam is to avoid over-reliance on a single customer and spread the risk
Hidden Costs from your Invoice Discounting Company
One important issue to look out for from an invoice discounting company is hidden costs when looking at whether or not invoice discounting is right for your unpaid invoices. Some invoice discounting companies will bring in clients with low rates and a trail period which leave out other costs.
Hidden invoice discounting costs include monthly minimums, administrative fees, set up fee, credit checking fees, same day payment fee, recourse fee, etc. Theses are usually hidden within the contract, so read carefully before signing.
Working with a transparent invoice discounting company that is honest about their fees is important. Always request a hard copy or email of the company’s costs and benefits for your specific situation.
Read more: Is invoice discounting cheaper than factoring
Conclusion
In conclusion, while invoice discounting can provide businesses with a valuable source of immediate cash flow, it also comes with inherent risks that need to be carefully managed. Credit risk, concentration risk, legal risk, and operational risk are some of the key risks associated with invoice discounting that businesses should be aware of and proactively address.
This includes conducting thorough credit checks on customers, diversifying the customer base, carefully reviewing and negotiating contracts and terms, implementing robust internal controls, and working with reputable and reliable financial institutions. By effectively managing these risks, businesses can mitigate potential losses, protect their financial interests, and ensure a successful and sustainable invoice discounting arrangement.
Seasoned professional with a strong passion for the world of business finance. With over twenty years of dedicated experience in the field, my journey into the world of business finance began with a relentless curiosity for understanding the intricate workings of financial systems.