Invoice discounting is an invoice finance facility that permits companies to accelerate payments on their invoices. There are three parties typically involved – the seller of goods or services, their buyer and a financier. Under invoice discounting, when an invoice is approved by a buyer, a proportion of the total amount can be made available from a financier immediately, providing an invaluable source of working capital throughout the month. This funding is provided before the buyer’s credit period has passed, provides a cash flow boost to the seller and assists with operational costs. The financier may be an external party like a bank or NBFC, or could be the buyer themselves using Treasury Funds.
Another way to look at invoice discounting is by considering it to be a working capital loan with invoices as security. At the end of the day, the financier realizes that the seller is owed the funds, so will loan the majority of it before the buyer has paid it and then on the due date get paid by the buyer. The financier will “discount” the total value of the invoice, i.e withhold a small percentage of the total amount. Typically this is higher than their own cost of capital but lower than the seller’s cost of capital.
Example:
- A steel distributor provides raw material to a furniture manufacturer and raises an invoice for the amount of ₹10 crore.
- The manufacturer has a standard credit period of 90 days, i.e. the invoice will be paid 90 days after approval.
- The financier, in this case a Bank, offers the seller immediate payment of ₹9 crore, withholding 10% of the total value.
- 10% is higher than the bank’s cost of capital, and the bank is happy to lend at this rate.
- 10% is lower than what the seller would take as interest on a loan from another bank, so is happy to take this reduction. The seller would pay a lot more in interest on a loan.
- The bank is paid by the manufacturer after 90 days. The manufacturer is happy since their credit period is preserved and at the same time, an important vendor’s financial health is not at risk.
How Does it Work?
On an everyday basis, invoices are sent out as work is finished or orders are satisfied. The invoice is discounted and early payment is provided once the invoice is approved by the buyer.
The cash can then be utilized to take care of bills, reimburse debts, or as a component of a long-term development plan. Raising and approving invoices following the work that has been finished is vital to the success of invoice discounting, as it allows for a customary flow of money consistently into the account.
Features
- Opens up the opportunity to bring quick money instead of waiting for invoice’s due dates.
- The rate of interest on invoice discounting is typically higher than the cost of capital for the buyer and the lender, but much lower than the cost of capital for the seller. This cost of capital gap is what makes invoice discounting possible.
- There is normally a processing charge too which can go from 0.2% to 0.5% of the turnover.
- While invoice discounting may reduce revenues for the seller, the faster movement of cash through the business more than compensates for this.
- Invoice discounting is an incredible method to smooth out incomes, helps in creating goodwill in the market, and gives the business a decent credit score over the long haul.
Benefits of Invoice Discounting
- Quick cash – Invoice discounting gives liquid money to a business against a receipt. It speeds up money inflow by changing over receivables into money. The money injection can be put to expanding sales, development plans, capital ventures, reimbursing debts, and so forth.
- Reduced credit period – The collection period is reduced and the supplier gets money early and on the other hand the buyer has plenty of time to pay his/her debts.
- No collateral as security – Cash can be gotten without utilizing any resources as insurance; just invoices to which buyers are yet to pay are submitted for the exchange. Financier require simply account receivables as collateral. No stock, property, or other versatile thing is used as collateral.
- A win-win situation for business – The borrowing organization can get the money it needs while the client can be given the credit period. This makes a mutually advantageous arrangement for the organization and the organization’s client which thus helps in building a sound connection between both the parties involved.
Challenges
Most traditional invoice discounting programs are manual and “one size fits all”. These programs apply a set of standard rules and protocols to all vendors, irrespective of the situation. They have a standard single discount rate for all vendors – while each vendor’s cost of capital is different. This affects participation across the supply chain. Traditional programs also sacrifice flexibility due to the impracticality of manually customizing a program across thousands of vendors. Vendors may need cash not at the time of order delivery, but say, 25 days later. They may need more cash 2 months before “season” to ramp up production. The buyer corporate too needs flexibility – in the mix of funding sources, eligible vendor segments and other structural aspects of the program. Lastly, such programs may have set criteria on which vendors may participate, and on what terms. For example, very often the logistics sector does not get access to vendor financing programs.
The end result is a lose-lose situation for buyers and sellers. Seller MSMEs cannot align the program with their business needs and do not participate, and the buyer corporate is unable to realize sufficient gains, monetary or otherwise.
Modern Invoice Discounting
Independent platforms like CashFlo allows deep program customization at both ends. Buyers can define the exact parameters – from available funds, to hurdle rate for financing, to which vendors can participate when, how they want to realize the gains, everything. And all this can be changed dynamically to match business strategy. Sellers can choose the invoices on which to avail early payment, they can do this at a time of their choosing and not necessarily only at the beginning of the credit period, and most importantly, they can choose the rate of financing that works for them. A large vendor may be OK with 9%, a small vendor may be ok with 14%. One vendor may need only 30 days early payment out of a 90 day credit period, another may want for the entire 90 days. Some vendors may want only in “season”, others may want year-round. All these vendors can participate through an independent platform.
