Invoice Discounting Meaning
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.read more where the businesses borrow the money in the form of loan from the finance company by keeping the amounts due from customers as the collateral, i.e., 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.
Example of Invoice Discounting
Suppose a US-based company B Inc. runs the business of manufacturing of cars and selling it 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 a period of 2 months.
However, the company received a bulk order from another party to supply the goods within a period of 1 month, but for this company requires the funds. Since the company has the account receivableAccount ReceivableAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read more of $ 500,000, it wants to go for the invoice discounting arrangement for the purpose of getting the cash because it does not have any other means of raising funds. Explain how much money he can get?
Solution
In the present case, recently, the company fulfilled the 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 who 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 20% ($100,000) the lender will give to the company once receive the payment from the customer after deducting the necessary fees.
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Advantages of Invoice Discounting
The various advantages related to the Invoice Discounting 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. read more, and using that money, it can pay to its supplier, employees, or can reinvest the same in some other operations of the business. So the company needs not to wait for their customers to make the payment against the 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 arrangement for the company.
Disadvantages of Invoice Discounting
The disadvantages related to the Invoice Discounting are as follows:
- For using the invoice discounting arrangement, 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 the cash inflow in the company.
- For the companies who are working on the low-profit margin, invoice discounting arrangement is not beneficial as interest and the fees included in the invoice discounting may eliminate the prospects of the company of earning the profits. So, this method is generally used by the works best for 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. read more as they can absorb much higher interest charges and the fees which are associated with invoice discounting form of financing.
Important Points Related to the Invoice Discounting
The different important points related to the Invoice Discounting 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 who wants to avail of this facility. Rest 20% will be given once the payment is received from the customer after deducting the necessary fees.
- Invoice discounting arrangement 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 the additional cash flow. However, the invoice discounting arrangement is not beneficial for the companies who are working on the low-profit margin because the interest and the fees included in the invoice discounting may eliminate the prospects of the company of earning the profits.
Conclusion
It refers to an arrangement in case of which the businesses borrows the money in the form of loan from the finance company where the accounts receivable from the customer is 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 the Invoice discounting, the company can improve its cash flow, and using that money, it can pay to its supplier, employees, or can reinvest the same in some other operations of the business. However, for using the invoice discounting arrangement, the businesses have to pay a certain percentage of the amount of the invoice to the finance company as the fee for the lending of the money.
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This article has been a guide to Invoice Discounting and its meaning. Here we discuss the example of the Invoice Discounting along with advantages and disadvantages. You can learn more about financing from the following articles –
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