Invoice discounting is a way to generate cash by keeping sale invoices as collateral with the financing institution by paying a service charge before the due date. It improves the working capital of the organisation.
What is meant by invoice discounting?
Invoice discounting enables the business to obtain a loan by keeping its trade receivable as collateral. A certain percentage of trade receivables is issued as a loan. This is a very effective financing solution as businesses receive advance cash due from customers through invoice discounting.
Purpose of invoice discounting
Invoice discounting increases the cash flow in the business organisation. This fund helps to accelerate additional growth. Here, instead of waiting for the customers to pay, one can discount the sales invoices from the lending institution to meet its cash requirements.
Who carries out invoice discounting?
- Invoice discounting company- Any company such as manufacturing, logistics, FMCG, pharmaceuticals, etc., can avail invoice discounting facility. It is a type of loan wherein funds can be availed against unpaid sales invoices.
- Lending institution- The lending institution charges a service fee for providing short-term loans against the unpaid sale invoices.
Invoice discounting process
- A business entity prepares invoices for goods sold to customers.
- These invoices are then sent to the lending institution for raising funds.
- The lending institution verifies the invoices and issues funds as per agreed terms. The funds are issued as a certain percentage of the invoice value.
- The invoice amount is collected by the business entity or the lending institution as per the agreement terms.
- When the customer makes a payment against the invoice, the amount received more than funds issued is returned to the business entity after deducting its service fee.
Advantages and disadvantages of invoice discounting
Below are some of the advantages of invoice discounting:
- Availability of cash- By using this type of financing, one can easily avail funds within 72 hours of applying. It is beneficial for businesses generating high-value invoices. A single unpaid invoice keeps a huge fund tied up.
- Protection from bad debts- A few lending institutions also provide protection against bad debts by charging a fee for additional services.
- Confidentiality- One can enter into a confidential invoice discounting if they fear losing customer confidence.
- Higher funds- As the business grows, one becomes more eligible to avail higher funds based on trade receivables.
- It brings a solution to slow payment. The funds raised can be used for business cash flow and dies to provide the necessary capital for business growth.
Below are some of the disadvantages of invoice discounting:
- Meet eligibility criteria- Small entities may not fit into the eligibility criteria of the lending institution. However, businesses can overcome this disadvantage by building a steady track record, instilling confidence among financers.
- Increase in cost- The financers charge a huge fee for providing invoice discounts. This will increase the business cost.
- No help in getting payments from customers- Unlike factoring, this discounting method does not provide any assured facility or assistance in collecting unpaid sales invoices.
Types of invoice discounting
- Whole turnover invoice discounting- In this type of invoice discounting, one can avail loan on each invoice generated in the business. Thus, funds can be raised on the total turnover.
- Confidential invoice discounting- This type of invoice discounting ensures confidentiality so that the customers and vendors of the businesses won’t come to know about such type of business arrangement.
- Selective invoice discounting- Only selective party invoices are given as collateral for raising funds under this type of invoice discounting.
Analysing the viability of invoice discounting
There are various financing options available in the market. Now the question arises, how to decide whether invoice discounting is suitable for your business? There are certain factors-
- Lower chances of bad debts.
- Receipt of timely payments from customers.
- Meeting minimum turnover levels for availing this financing facility.
- Robust credit control measures are being followed in the organisation.
If a particular organisation meets all the above factors, it can go for invoice discounting.
Comparison between invoice discounting and invoice factoring
Invoice factoring and invoice discounting are similar. In both types of financing agreements, funds are issued against unpaid sales invoices. However, the fundamental difference between factoring and invoice discounting is managing the credit control process and collecting payments from customers.
In factoring, the lending institution manages the sales ledger and credit control process. The responsibility of collecting money from customers is that of the financing entity. Here, the lending institution buys the sales invoice.
In invoice discounting, the responsibility of collecting money from customers is that of the business entity. Thus, complete confidentiality is maintained in this type of financing arrangement. Here, the sales invoices are just used as collateral for providing short-term loans.