Invoice discounting helps businesses take out loans by keeping the trade receivable as collateral. Some percentage of the trade receivable is given as a loan. This is an effective way of financing as the business receives advance cash. This is what is known as invoice discounting.

What is invoice discounting for businesses?

Invoice discounting is the working capital solution that is very popular among businesses nowadays. This process involves selling the unpaid invoices to third-party finance providers, who pay up to 75% of the business invoice and will receive the remaining invoice of 25% once the business’s client clears the invoice.

One of the significant advantages of invoice discounting is that it helps in business growth by offering cash flow. This further allows businesses to use the cash to invest in new technology, equipment or products, take new orders, hire professionals or pay for pending expenses. Thus, businesses stay ahead of the competition.

Who can do invoice discounting?

Companies like logistics, manufacturing, pharmaceuticals, FMCG, and more can use the discounting invoice facility. It is a type of loan where funds can be taken against any unpaid invoices.

Lending institution is the other party involved in the process wherein they charge a service fee for offering short term invoice discounting loan against the unpaid invoices.

Advantages and limitations of Invoice Discounting

Advantages of invoice discounting:

Cash flow

Using such financing, you can easily take funds within no time. It is good for businesses that generate high-value sales invoices.

Bad debts protection

Some lending companies protect bad debts by charging fees for the additional services they may provide for discounting invoice.

More funds

As businesses grow, you can become more eligible to take higher funds on the trade receivables.

Better solution

Invoice discounting offers great solution for slow payments. The funds you raise can be used for cash flow and necessary capital for growth and expansion.

Limitations of invoice discounting:

Increased cost

The lending institutions may charge high fees for invoice discounts. This may further increase business costs.

No guarantee of getting payments from clients/customers

Unlike invoice factoring, discounting does not guarantee any assured benefit or help in collecting sales invoices.

Strict eligibility criteria

Small firms may not fit in the eligibility criteria of the lending company. However, businesses can overcome this by having a solid track record, thus instilling confidence in the financer.

Invoice discounting example

If you take a loan of Rs 20,000 with a lending institution, they will give you an advance of up to 75 or 80 percent of your invoice amount. So, you may get Rs 15,000 or Rs 16,000. When the customer/client pays for the invoice on the due date, you get a balance of Rs 5000/4000. So, in this case, Rs 4000/5000 was the discount.

Invoice Discounting Process

1. The business prepares sales invoices for the goods sold to its customers.
2. These sales invoices are sent to lending institutions to get funds.
3. Then the lending institution checks the invoices and issues funds according to the agreed terms and conditions. The funds are issued per the invoice value percentage decided by the lending institution and the business.
4. The invoice amount is collected by the business or lending institution as per agreement terms (invoice discounting or invoice factoring).
5. As the customer makes payment against the sales invoice to the business, the amount received more than the funds issued is then returned to the business after deducting the service fee of the lending institution.

Types of Invoice Discounting

Whole turnover ID

Under this type of discounting, one can take a loan on each invoice generated. Thus, funds can be taken on total turnover.

Confidential ID

This type of discounting ensures confidentiality so that the vendors and customers won’t know about such a type of cash flow arrangement.

Selective ID

This type of invoice discounting is where only selective invoices are provided as collateral for raising the funds.

Viability of Invoice Discounting

There are many financing options available for businesses. How do you know whether invoice discounting is right for your business or not? Here are a few factors to keep in mind-

• Timely payment receipts from customers
• Solid credit control steps to be followed in the organization
• Lower chances of facing bad debts
• Meeting minimum turnover for getting the financing facility

So, if a business meets all of these above-mentioned factors, they can opt for an invoice discounting facility.

Invoice discounting vs invoice factoring- what’s the difference?

Even though invoice discounting and factoring will give you an advance against the unpaid sales invoices, they work differently. While invoice discounting is a loan, invoice factoring company buys the unpaid invoices at some discount. It may be a small difference, but it is also a critical one.

The invoice factoring companies take credit control, which means they deal with the customers and chase the late payments instead of the business doing it. Also, it can be non-recourse, meaning that if you sell the invoice to a lending company and the customer doesn’t pay, you don’t have to pay back the money on your own. The fee is generally higher for the nonrecourse factoring, but it gives you peace of mind. As invoice discounting is a loan, the money must be repaid.

The invoice factoring institutions check your customers’ credit before they agree to buy the invoices. This further helps to remove the potential bad payers. Also, there are different risks associated with invoice discounting and invoice factoring. Discounting is a greater risk for lenders as compared to factoring. And due to that, discounting is used by large companies that have reliable customers. On the other hand, smaller companies use factoring as it is more accessible.

Considerations for discounting invoice

Impact on profit margin

It is an additional cost to be borne by any business. This further reduces the margin level on the discounted invoices. Costs can also be hidden by discounting entity when it comes to credit rating costs, administrative charges, processing fees and, application charges etc. A business needs to analyze the cost appetite and see all available discounting options before choosing the right discount entity. Also, the flexibility available on discount rates is essential.  A program that offers a fixed rate and tenure discounting may cause a business to bear more charges than required. However, budding businesses may cover these charges and reap invoice discounting benefits.

Personal guarantee

Companies prefer invoice discounts as they are an unsecured source of money. This implies that the business offers some sort of guarantee to the lending entity. When the invoice is not paid or gets delayed, it can impose legal consequences on the business.

Over-reliance

A business should not rely a lot on invoice discounting as the main source of taking short-term finance. Though it helps to maintain the working capital, it cannot be used in all situations. Relying too much on invoice discounting can be tricky and risky when the debtor does not have a high credit score. You may also have to bear the high charges. Thus, businesses should understand that it is not to be taken as a source of long-term capital, and so a business should be flexible about its finance sources and use discounting only when required.

Customer disputes

Disputes that may arise with customers during the credit period can reduce the probability of payment receipt. This can affect the business negatively when the customer doesn’t pay. Businesses should maintain good customer relations and set terms and conditions before raising any invoice. Any problem in customer relationships can affect the discounting system indirectly.

Debtor credit rating

The debtor’s creditworthiness decides if the invoices actually qualify for any discounts. If the debtors have low creditworthiness, then the discounting entity will not entertain discounting the invoices. Also, the entities may increase the discounting rates to make up for the credit risk. Debtor’s insolvency will shift the repayment burden back to the business. Thus, businesses can trust invoice discounting only in case of payments from customers.

Withdrawal arrangements

As a business enters the contract, exiting from such an arrangement is tough. Exiting the discounting contract requires the business to pay full borrowed cash plus added charges. If business is short on its working capital, it may not be feasible and may face considerable cash shortage.

FAQs

Which invoices can be discounted?

Any unpaid final invoice becomes eligible for discounting.

What is the eligibility criterion for invoice discounting?

Businesses that qualify invoice discounting have lower chances of poor debt, expect customer payments on time, meet minimum turnover level and follow solid credit control measures.

How to know if invoice discounting is right for a business?

In case of any unpaid invoices by your business, with a record of getting paid within due date, meets turnover criteria and follows all credit control steps. You can explore the invoice discounting option.

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Conclusion

To sum up, invoice discounting is a feasible financing option for businesses of different sizes, especially for those that deal with long-term payments. It offers various benefits like better cash flow, improved control over finances, and low interest rates compared with traditional loans. At the same time, it also has some limitations like high costs and risk of customer relationship getting affected. Despite all this, with growing technology, invoice discounting has become an easy and accessible option. With careful consideration and choosing the right platform, businesses can manage their capital requirements and achieve financial goals.