Types Of Invoice Discounting In Finance
Our related article "Types of Factoring" showed how the financial product "invoice discounting" (often abbreviated to ID) fits into a hierarchy of financial products called "invoice finance". These are working capital finance products that allow businesses to get advances of cash against unpaid sales invoices. This can dramatically improve their cash flow.
In the UK, the principle difference between factoring and invoice discounting facilities is that with the later, no credit control service is provided by the finance company (known as a "discounter"). However, there are many types of invoice discounting in finance, and this article seeks to explain the different types in easy to understand terms.
Debt factoring deserves a mention, as an alternative to discounting, which generally presents a lower risk profile due to the active involvement of the financier in collecting payments from customers. If you don't qualify for discounting, factoring is likely to be available, even if you have previous adverse credit history including CCJs or being in a CVA.
Our definition of invoice discounting is as follows:
"A financial service for businesses, whereby a discounter provides prepayments against the unpaid credit invoices of a business, in order to improve it's cash flow".
That definition is correct in the very simplest sense of these services, however there are many product variables that could be present to enhance that definition.
You can find a full explanation of how these products work, together with pricing on our invoice discounting product page.
The history of discounting apparently dates back to the time of King Hammurabi of Mesopotamia, some 4,000 years ago. However, this type of financing only emerged in the formats that we see today in the middle ages. It is thought to have emerged in the 1300's/1400's. Jewish businessmen were apparently fleeing persecution in Spain to Italy and began lending money against the delivery and payment of grain. Merchants emerged that solely bought and traded grain debt.
By the 1600's and 1700's, this type of financing had become common. London's merchant bankers regularly advanced funds to American colonists in respect of goods and materials before the goods made their way across the sea.
Since that time, the idea of providing finance against debts has become increasingly popular, as an alternative to more traditional bank finance such as overdrafts and loans. This kind of funding falls under the ultimate product umbrella of "asset finance" - finance provided against the assets of a business. In this case, it is the book debts, all the unpaid sales invoices of the company, that are the asset that is used as security for the finance.
There are now a large number of discounters in the UK, we estimate that over 60 providers from our list of invoice finance companies now provide discounting services. The ABFA (Asset Based Finance Association) is the principle industry body for the discounting industry. According to their Q4 2016 figures, there are now 20,159 clients of their members using domestic ID, with this having increased by 2% since the previous year. These clients have apparently discounted invoices worth £256,605 million during 2016, a huge number.
This growth in the number of providers offering these services has gone hand-in-hand with an expansion in the variety of different product types that are on the UK market. There are many nuances in the way that this kind of funding can work, and there are now a large selection of different funding options that are available to clients.
Historically, clients had to discount all of their invoices (perhaps with a few mutually agreed exclusions) but in recent times completely selective offerings have emerged, delivering ultimate flexibility for anyone that does not want to be tied into an ongoing contract. Selective or single invoice discounting has become common place in the UK, over the last few year. We have seen a rapid increase in the number of providers offering these services, many of them small independent providers.
There is also a great deal of difference between the offerings of the various ID providers in the UK. Many of these have emerged in order to gain some kind of competitive advantage, many have been offered since the 70s and 80s. The risk profile of each product differs such that it will drive the crtieria that that the discounter places on companies in order to qualify for a particular product.
Firstly, you could split the providers by whether they are banks or independent companies. There are also huge differences between the methods of operation between individual providers. At one end of the spectrum facility are relatively manual, perhaps with documents such as invoice schedules being electronically transmitted. Whilst at the other end of the spectrum, there are fully automated sales ledger upload facilities, that automatically reconcile the discounter's figures to the sales ledger of the client, and the cash items that have been received into the trust account - hence eliminating reconciliations. This has enabled some providers to move increasingly towards a quasi "debtor backed overdraft" method of operating.
There are now numerous flavours of discounting available in the UK and this article describes each of the types in some detail. We have concentrated on what makes each of them unique, rather than repeating the basics of any discount facility i.e. that you receive finance against your unpaid invoices to customers.
Types Of ID
These are some of the different types of ID facility found in the UK. Note that in some cases brand names will be used for particular product offerings. Understanding the functionality delivered by a particular product will enable you to classify it and identify it as one of the following product types.
Confidential Invoice Discounting (CID) And Disclosed
If the product is offered on a confidential basis, then customers are intended to be unaware that they client is using the service. In some cases a client may prefer this as it leaves their relationships with their customers unaffected.
No notice of assignment letter is sent to the debtors at the outset, and the sales invoices do not bear an assignment clause. The statements and chasing letters are all sent by the client, who also makes all the credit control telephone calls to the customers. If you need to know how to run your own credit control function please look at our free guide. In this way, the client is able to maintain their own in-house credit control function, using their own staff or credit controllers.
When the customer's pay, they pay into a "trust account" which is set up and controlled by the discounter. However, it is an account in the name of the client, so to a debtor it will appear to be their account. When the account is first set up, the customers will need to be asked to change their payment details to the new bank account.
Even when the discounter's auditors conduct telephone debt verification, during an audit (often conducted quarterly), they will call in the client's name, maintaining that confidentiality. They are likely to speak to a random sample of customers in order to confirm the balances that are outstanding. This is part of the discounter's security control measures and is aimed at identifying any invoices that are not legitimately valid and payable e.g. pre-invoicing or fictitious (fresh air) invoices.
As the discount service is confidential, this presents a higher level of risk to the discounter. In the event of their client failing, the customers could pay the wrong party as they have not been notified of the assignment of the debts. Therefore, the financiers are likely to have more stringent criteria for offering these services, as opposed to say factoring which is often offered despite poor credit standing. These may be financial criteria e.g. regarding profitability and net worth, but also an ability to demonstrate that you can run your own credit control e.g. a good debt turn and procedures.
The ABFA statistics to the end of 2016 show that the average debtor days outstanding, amongst the clients of its members that were using discount services, was 56.1 days on average. Assming that average credit terms are going to be around 30 days this evidences the quality of the credit control procedures of this segment of clients.
Bulk Processing, Shadow Ledger & Sales Ledger Upload
It is common with ID for the discounter not to keep a sales ledger, but rather to adjust control balances for the total value of debts. This is called "bulk" processing. This sometimes requires that the client reconciles their sales ledger to the discounters control balances, on a regular basis (often monthly), called the "reconciliation". The alternative is to operate what is called a "shadow ledger" where individual items are processed to a duplicate of the client's sales ledger.
There is another method of operation, that has emerged in recent years, called "sales ledger upload". Software has been developed that integrates with your accounting software, and enables you to upload your entire sale ledger to the discounter. In some cases, many interfaces have been built with all the well known accounting software, ensuring compatibility wiht a range of different accounting packages.
The process of uploading the ledger can be set to happen automatically, minimising your workload, or it can be triggered manually. The discounter then makes prepayments based on the figures that they draw from your accounting software (they are likely to use sophisticated analysis software to analyse your sales ledger). In some cases this software also undertakes the monthly reconciliation for you, removing the need to undertake a monthly reconciliation manually. This can save a lot of your time. In such cases, the software takes a feed from the bank account of the items received, and looks to pair them up with the items on the sales ledger. This may happen item to item, or in some cases it is just a total balance of movements that is checked, often within an allowed level of tolerance.
How To Tell If Someone Is Using Confidential Invoice Discounting
If you really want to know if a company is using confidential invoice discounting, there is a way of telling.
It is normal for the discounter to register a charge over the book debts, or a debenture at Companies House. This is a type of security that grants them certain rights, over the assets of the company, should any borrowing fail to be repaid. This type of security has to be registered at Companies House, and the record will show the name of the company that registered it i.e. the discounter.
You can find a list of discounters on our site, and you can search the register at Companies House for any company to view its accounts, Directors and registered documents. There will be a copy of any charges or debentures under the "Charges" section and you can check to see if any known discounters hold charges.
The only drawback to this method is when they are using a bank. Sometimes you cannot distinguish between a company using a bank for an overdraft or loan or ID, as the charge may look similar.
Disclosed Invoice Discounting (DID)
As the name suggests this product is not confidential from customers, but once again the client maintains their own invoice collection function. There will be general notice of assignment letters sent at the outset of the arrangement, advising the customers of the discounters involvement, and there will normally be a notice of assignment required to be added to every new invoice.
The facility will normally be operated on a "bulk" basis but in some cases there may be a "shadow sales ledger". Prepayments are made against your invoices as described previously.
The disclosed nature of the facility puts the financier in a safer risk position, so they are likely to be able to offer this kind of service to customers that may not have qualified for a confidential facility.
Recourse and Non Recourse
Both CID and DID can operate on either a recourse and a non recourse basis (non recourse includes bad debt protection). Recourse is most common in the UK, it effectively means that if an invoice is not paid after a defined (and extended) period of time (recourse period), the prepayment against that invoices has to be repaid. In practice it is often prepayments against new invoicing that offset any invoices that recourse, rather than the client having to come up with the money. This is one of the benefits of discounting your whole sales ledger.
Protected ID (PID)
Protected invoice discounting also includes bad debt protection, such that if a covered invoice (one that falls within the credit limit the discounter sets for your customer) is not paid within an agreed period of time (credit period), you receive the balance of the invoice from the discounter. This is instead of recourse. This is also known as bad debt protection or non recourse. It sometimes applies only to insolvency of the customer, so you need to check the terms. There may also be a first loss clause and/or a limiitation on the level of cover e.g. 90% with some suppliers, 100% with others.
You are also not covered in the event of a dispute.
Selective Or Whole Turnover ID
You can either choose to include all your sales invoices in the ID arrangement, in order to maximise funding, or you can select individual invoices to discount. Selective will be more expensive if you have an ongoing need for funding, but advantageous if you want to dip in and out of the funding, with no minimums of contract to submit further invoices for discounting.
With selective you can submit single, or batches of invoices to be funded - this can be a great "in case of need" facility to smooth out any cash flow humps.
Customer Handles Own Collections (CHOCs)
Customer handles own collections (CHOCs) is sometimes also called CHOCCs (customer handles own credit control). This is a product where the customer undertakes all their own credit control activity, but the involvement of the discounter is disclosed to the customers. This can put the discounter in a more secure position such that they may be able to offer this product to a customers that might not qualify for a confidential product.
A shadow sales ledger is normally maintained by the discounter.
Export ID (EID)
Discounting services are also available for export invoices, to foreign debtors. This can be in conjunction with UK debtors (domestic and export), or solely for export customers. Not all countries are able to be handled, but many are. The discounter will be able to advise you as to which territories they can handle.
Figures from the ABFA to the end of Q4 2016 suggest that export ID sales, year to date, have grown by 30% since the previous year.
So to summarise, the key feature of invoice discounting, as distinct from factoring, is that it offers prepayments against your invoices, whilst allowing you to retain your own credit control activity. The facility may be confidential from your customers, or disclosed so that they are aware that you are using the service. There are also different ways of processing your invoices, bulk, shadow ledger or sale ledger upload.
You can use ID for both UK and export debts, and you can either select invoices to discount or discount them all. Bad debt protection (non recourse) is an option in many cases, and may be a requirement in some cases.
See our explanation of the: Invoice Discounting Product Related Decision Making Tree.
As with any other products, the service delivery between different providers may differ. Despite the fact that you are undertaking your own credit control function, there is still likely to be interaction with the financier so service levels often matter. We have undertaken extensive research into provider service levels and they vary widely, even regarding ID products.
There are likely to be pricing differences but also the exact modus operandi my vary. Many financiers also employ product names which can further complicate your understanding of the product.