Invoice Discounting Meaning
Invoice Discounting refers to the form of the invoice financing where the businesses borrows the money in 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 and as per the terms and conditions of the company; the customer will make the payment of $ 500,000 against the sale of goods after the 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 receivable 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 the 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 the period of 2 months as per the terms and conditions of the company. However company received a bulk order from another party to supply the goods within the period of 1 month, but for this company requires the funds so 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 the funds.
In case of the invoice discounting arrangement, 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. So B Inc will get 80% of the $ 500,000 from the finance company which will come to $ 400,000. Also, the rest 20% ($100,000) will be given to the company from the lender once the payment is received from the customer after deducting the necessary fees.
Advantages of Invoice Discounting
The various different advantages related to the Invoice Discounting are as follows:
- Using the Invoice discounting approach, 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. So the company needs not wait for their customers to make the payment against the due in order to raise the money and it can receive the money just after issuing the invoice.
- From the perspective of the finance company also, the invoice discounting is beneficial, as the finance company will receive the money in two ways i.e., by the way of charging the interest on the loan and by the 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 margins as they are able to 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 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 and 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 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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