What is Invoice Discounting?
Invoice Discounting refers to the form of the invoice financing where the businesses borrow the money in the form of a 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.
The amount of debt issued by the finance company is less than the total amount of outstanding receivables (typically 80% of all invoices less than 90 days old).
The finance company is generally not more selective than simply allowing a percentage of all invoices outstanding, thereby relying on a spread of receivables among many customers to keep from losing collateral.
Purpose of Invoice Discounting
Invoice discounting increases the cash flow in the business organization. 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.
How Does Invoice Discounting Work?
A business sells a good or provides a service to a customer.
- The seller invoices the client, giving them up to 120 days to pay.
- The business then sends the invoice to a third party, usually called a financing company.
- The financing company buys the account receivable from the business. Funds are made available at a certain percentage of the face value of the invoice (~80%).
- When the customer makes a payment, the balance of the invoice is remitted back to the business, minus a service fee.
Types of Invoice Discounting
- Whole turnover invoice discounting: This financing method is where you use the entire value of your accounts receivable ledger with the invoice discount company. It can often be helpful for businesses with reliable customers and clients and allows the invoice discounting company to have a wider range of risks.
- Selective invoice discounting: This financing method is where you choose to discount a few invoices, like your largest account perhaps, though it’s often only an option for larger companies and businesses.
Advantages of Invoice Discounting
The various pros/ advantages related to the Invoice Discounting are as follows:
- Improves cash flow: As cash is raised as soon as the invoice is issued cash flow it can allow for better control over investment and growth decisions and improved business operations.
- It’s a quicker way to obtain financing: Unlike other business loans invoice financing provides cash quicker with a reduced need for overdrafts or other debt facilities.
- No risk to assets: Invoice financing is an unsecured business loan paid in lieu of invoices.
- No impact on customer relations: As the invoice discounting company has no contact with the customer there is no need for them to be aware of the situation, customer confidentiality is maintained.
- Boost to credit sales: Invoice discounting takes sales made on credit and convert it into cash.
Disadvantages of Invoice Discounting
The disadvantages related to the Invoice Discounting are as follows:
- Overall profit is reduced: The discounting company charges a fee for the loan so in the short term there will be a decrease on the profits made. This can however be counterbalanced by opportunities gained with early access to cash providing increased access to business opportunities.
- Restricted availability: As this is an unsecured loan and risky for the lender, invoice financing is generally only available for commercial invoices which can be a barrier to business that deal only with the public.
- May not be the cheapest invoice finance solution: Comparisons should be made with other forms of loan, they may be cheaper
- Restricted financing: If a business is looking for a specific sum of money then loaning against their accounts receivables may not provide enough funding.
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 additional cash flow. However, the invoice discounting arrangement is not beneficial for the companies who are working on a low-profit margin because the interest and the fees included in the invoice discounting may eliminate the prospects of the company earning the profits.
Using Invoice discounting, the company can improve its cash flow, and using that money, it can pay its supplier, and 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.
Alia Noor (FCMA, CIMA, MBA, GCC VAT Comp Dip, Oxford fintech programme, COSO Framework)Associate Partner
Ahmad Alagbari Chartered Accountants