What Is Invoice Discounting?
Invoice Discounting refers to the form of the invoice financingInvoice FinancingInvoice Financing is way to obtain funds for short term liquidity needs of a company by keeping account receivables as a collateral. These funds are usually utilized to pay off the short term liabilities like salaries, creditors etc. where the businesses borrow the money in the form of a loan from the finance company by keeping the amounts due from customers as the collateral, The business can get the cash that it was supposed to receive in future in today’s date.
In this process, accounts receivable from the customer is used as the collateral for the loan and the finance company in return issues the loan which is less than the amount receivable from the customer as per the invoice. It is good for firms facing a cash crunch but customer should have good credit score to honour the payments on the due date.
Invoice Discounting Explained
Invoice discounting facility refers to an arrangement in the case which the business borrows the money in the form of a loan from the finance company where the accounts receivable from the customer are used as the collateral for the loan, and the finance company issues the loan which is less than the amount receivable from the customer as per the invoice.
Using Invoice discounting, the company can improve its cash flow, and using that money, it can pay its supplier, and employees, or reinvest the same in other business operations. However, for using the services of invoice discounting companies, the businesses have to pay a certain percentage of the invoice amount to the finance company as the fee for the lending of the money.
This method should not be used as a primary or an important source of funds for the business. Even though this is a great source of short-term financing and is useful in maintaining the working capital needs, which is very important to run the day to day operational expenses, it is not a good idea to depend too much on it because it is risky due to the fact that the borrower or the buyer may not be able to honour the payment terms on the due date and in that case the receivable used as collateral will lose its value.
The different important points related to the invoice discounting facility are as follows:
- In the case of the invoice discounting arrangement, the finance company issues the loan, which is less than the amount receivable from the customer as per the invoice. Generally, the loan equivalent to 80% of the value of the invoice is given by the finance company to the business that wants to avail of this facility. The Remaining 20% will be given once the payment is received from the customer after deducting the necessary fees.
- Invoice discounting agreement is common and beneficial for the company, which is doing the high-profit businesses because they are growing at a rapid pace. For further growth, they require additional cash flow. However, the invoice discounting arrangement is not beneficial for the companies who are working on a low-profit margin because the interest and the fees included in the invoice discounting may eliminate the prospects of the company earning the profits.
Suppose a US-based company B Inc. runs the business of manufacturing cars and selling them in the market. The company gives the credit of 2 months generally to its customer after selling the product from the date of issue of the invoice. Recently the company fulfilled the huge order which it received from one of its customers. As per the terms and conditions of the company, the customer will make the payment of $ 500,000 against the sale of goods after 2 months.
However, the company received a bulk order from another party to supply the goods within one month, but this company requires the funds. Since the company has an account receivableAccount ReceivableAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. of $ 500,000, it wants to go for the service of invoice discounting companies to get the cash because it does not have any other means of raising funds. Explain how much money he can get?
In the present case, recently, the company fulfilled a huge order against which the customer will make the payment of $ 500,000 after 2 months as per the terms and conditions. However, the company received a bulk order from another party to supply the goods within 1 month. Still, this company requires the funds, so it wants to go for the invoice discounting arrangement to get the cash because it does not have any other means of raising funds.
In the case of invoice discounting arrangement, generally, the loan equivalent to 80% of the invoice value is given by the finance company to the business that wants to avail of the facility. So B Inc will get 80% of the $ 500,000 from the finance company, which will come to $ 400,000. Also, the rest of the 20% ($100,000) the lender will give to the company once receive the payment from the customer after deducting the necessary fees.
The various advantages related to the invoice discounting finance are as follows:
- Using the Invoice discounting approach, the company can improve its cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. , and using that money, it can pay its supplier, and employees, or can reinvest the same in some other operations of the business. So the company does not need to wait for their customers to make the payment due to raising the money, and it can receive the money just after issuing the invoice.
- From the perspective of the finance company also, invoice discounting is beneficial, as the finance company will receive the money in two ways, i.e., by way of charging the interest on the loan and by way of charging the monthly fees for maintaining such an arrangement for the company.
The disadvantages related to the Invoice Discounting are as follows:
- For using the invoice discounting finance, the businesses have to pay a certain percentage of the amount of the invoice issued to the customer to the finance company as the fee for the lending of the money. Due to fees of a substantial amount, the company prefers this discounting method only when there are no other means of cash inflow in the company.
- For the companies who are working on a low-profit margin, the invoice discounting agreement is not beneficial as interest and the fees included in the invoice discounting may eliminate the prospects of the company earning the profits. So, this method is generally used by companies who are working on the high-profit margin with relatively high-profit marginsProfit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. as they can absorb much higher interest charges and the fees which are associated with invoice discounting form of financing.
Invoice Discounting Vs Factoring
Let us try to understand the differences between the above two methods.
- The former is a loan granted against outstanding invoices whereas the latter is a situation where the factoring company buys the invoices.
- In the former, the lender does not get the chance to deal directly with the customers whereas for the latter, the factoring company directly deals with the customers.
- The business does not have to chase for payment collection in case of factoring but for the discounting the business has to collect the payment themselves.
- Factoring spares the business from any obligation if the customer does not pay but such is not the case with discounting.
This article has been a guide to what is Invoice Discounting. We explain its differences with factoring, advantages, disadvantages with examples & features. You can learn more about financing from the following articles –