Invoice discounting is the practice of using a company's unpaid accounts receivable as collateral for a loan, which is issued by a finance company. This is an extremely short-term form of borrowing, since the finance company can alter the amount of debt outstanding as soon as the amount of accounts receivable collateral changes. The amount of debt issued by the finance company is less than the total amount of outstanding receivables (typically 80% of all invoices less than 90 days old). The finance company is generally not more selective than simply allowing a percentage of all invoices outstanding, thereby relying on a spread of receivables among many customers to keep from losing collateral.
Invoice discounting essentially accelerates cash flow from customers, so that instead of waiting for customers to pay within their normal credit terms, you receive cash almost as soon as you issue the invoice.
The finance company earns money both from the interest rate it charges on the loan (which is well above the prime rate), and from a monthly fee to maintain the arrangement. The amount of interest that it charges the borrower is based on the amount of funds loaned, not the amount of funds available to be loaned.
Invoice discounting is impossible if another lender already has blanket title to all company assets as collateral on a different loan. In such situations, the other lender needs to waive its right to the accounts receivable collateral, and instead take a junior position behind the finance company.
From an operational perspective, the borrower sends an accounts receivable report to the finance company at least once a month, aggregating receivables into the categories required by the finance company. The finance company uses this information to adjust the amount of debt that it is willing to loan the borrower. The borrower retains control over the accounts receivable, which means that it is responsible for extending credit to customers, invoicing them, and collecting from them. There is no need to notify customers of the discounting arrangement.
Invoice discounting works best for companies with relatively high profit margins, since they can readily absorb the higher interest charges associated with this form of financing. It is especially common in high-profit businesses that are growing at a rapid rate, and need the cash flow to fund additional growth. Conversely, this is not a good form of financing for low-margin businesses, since the interest on the debt may eliminate any prospect of earning a profit.
Invoice discounting tends to be a financing source of last resort, because of the substantial fees associated with it. You would normally use it only after most other forms of financing have been attempted. As noted earlier, the key issue for leaving invoice discounting open as a financing alternative is to not include accounts receivable in the collateral for any other debt arrangements.