Invoice Discounting Meaning Example Advantages Disadvantages

Invoice Discounting Meaning

Invoice Discounting refers to the form of the invoice financingInvoice FinancingInvoice Financing is way to obtain funds for short term liquidity needs of a company by keeping account receivables as a collateral. These funds are usually utilized to pay off the short term liabilities like salaries, creditors etc.read more 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.

Example of Invoice Discounting

Suppose a US-based company B Inc. runs the business of manufacturing cars and selling them 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. As per the terms and conditions of the company, the customer will make the payment of $ 500,000 against the sale of goods after 2 months.

However, the company received a bulk order from another party to supply the goods within 1 month, but this company requires the funds. Since the company has an account receivableAccount ReceivableAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more of $ 500,000, it wants to go for the invoice discounting arrangement to get the cash because it does not have any other means of raising funds. Explain how much money he can get?

Solution

In the present case, recently, the company fulfilled a huge order against which the customer will make the payment of $ 500,000 after 2 months as per the terms and conditions. However, the company received a bulk order from another party to supply the goods within 1 month. Still, this company requires the funds, so it wants to go for the invoice discounting arrangement to get the cash because it does not have any other means of raising funds.

In the case of invoice discounting arrangement, generally, the loan equivalent to 80% of the invoice value is given by the finance company to the business that wants to avail of the facility. So B Inc will get 80% of the $ 500,000 from the finance company, which will come to $ 400,000. Also, the rest of the 20% ($100,000) the lender will give to the company once receive the payment from the customer after deducting the necessary fees.

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Advantages of Invoice Discounting

The various advantages related to the Invoice Discounting are as follows:

Using the Invoice discounting approach, the company can improve its cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more, and using that money, it can pay its supplier, and employees, or can reinvest the same in some other operations of the business. So the company does not need to wait for their customers to make the payment due to raising the money, and it can receive the money just after issuing the invoice.From the perspective of the finance company also, invoice discounting is beneficial, as the finance company will receive the money in two ways, i.e., by way of charging the interest on the loan and by way of charging the monthly fees for maintaining such an 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 cash inflow in the company.For the companies who are working on a low-profit margin, the invoice discounting arrangement is not beneficial as interest and the fees included in the invoice discounting may eliminate the prospects of the company earning the profits. So, this method is generally used by companies who are working on the high-profit margin with relatively high-profit marginsProfit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more as they can absorb much higher interest charges and the fees which are associated with invoice discounting form of financing.

The different important points related to the Invoice Discounting are as follows:

In the 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 that wants to avail of this facility. The Remaining 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. 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.

Conclusion

It refers to an arrangement in the case which the business borrows the money in the form of a loan from the finance company where the accounts receivable from the customer are 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 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.