What is Invoice Discounting?
Invoice discounting is a popular and widely used tool for companies to better manage their cash flow positions. The basic concept of invoice discounting is that it allows a company to take a loan against its Accounts Receivables (AR) or unpaid sales invoices. While factoring is an outright sale of a company’s invoice to a factor, invoice discounting is just a loan from a bank or financier which sanctions the loan against the invoices that are held as collateral. It allows a company to avail a loan against its book debts or accounts receivables.
How Does it Work?
The first step for a bank would be to assess the quantum of the invoices and the general credit quality of the debtors. Once the bank has convinced itself that the invoices are likely to be paid within the stipulated time, they would sanction some limits and allow the client to draw down up to a certain percentage of the total outstanding invoice value. This percentage would vary from industry to industry and also be based upon the track record and credit rating of the client’s debtors.
The bank would charge a fixed fee to sanction the facility and an interest rate which would depend on the tenor of the facility (it’s usually short term only) and the perceived risk. The facility is secured by the creation of a charge on the book debts by the bank. Since the company retains control of the actual collection of the invoice amount, the strength of the company’s ability to recover and their track record of recovery is an important lending criterion. Overdue invoices would not be considered a good credit sign and could limit the ability for invoice discounting eligibility.
Invoice Discounting Benefits
The benefits are similar to factoring, but there are a few differences. Here we discuss some of them:
- If there is no charge on book debts already, the company can utilize that asset to get cheaper funding
- The cash flow situation improves significantly as funding may be received on day one of the invoices
- The bank or financial institution providing the facility may offer other allied services at a cheaper rate
- The company may be able to offer more favorable terms to their buyers and thus expand their business. For example, if they could only offer 10 days credit earlier due to a tight cash flow situation, they may now be able to offer 30 days and still get the money on day 1
- Invoice discounting is “discreet”, meaning the buyer does not know if the company has taken a loan against the invoices – this may prove to be of immense value in some situations
- The responsibility to collect against the invoices remains with the company itself and they continue engaging with their clients, which is not the case in a factoring arrangement
The best situation to use invoice discounting is when a cash infusion is required discreetly without the customers having to deal with a factor to make the payment against the invoices raised against them. A company that wants to strengthen its relationship with its customers and can actually do a better job at collections due to that relationship would prefer invoice discounting over factoring.