Invoice discounting is a type of short-term borrowing often used by businesses to improve their cash flow. It involves using a company’s unpaid invoices as collateral for a loan.
Here’s how it generally works:
- A business sells goods or services to a customer and issues an invoice.
- Instead of waiting for the customer to pay the invoice, the business can take the invoice to a financial institution or a specialized invoice discounting company.
- The invoice discounting company gives the business a percentage of the invoice value upfront (usually around 80-90%) and charges a fee for this service.
- When the customer pays the invoice, the payment goes to the invoice discounting company.
- The invoice discounting company then gives the remaining balance of the invoice to the business, minus their fees and any interest.
Invoice discounting can be an effective way for businesses to manage their cash flow and gain access to funds without waiting for customers to pay their invoices. It’s also typically confidential, meaning that the customers may not be aware that their invoices are being financed in this way.
However, it’s worth noting that businesses are still responsible for collecting payments from customers. This distinguishes invoice discounting from invoice factoring, where the factoring company takes over the responsibility of collecting payments. Also, if a customer fails to pay, the business typically has to repay the discounted amount to the financier.
Example of Invoice Discounting
Let’s consider an example of a fictional manufacturing company, “FastForward Manufacturing,” that uses invoice discounting:
FastForward Manufacturing has just completed a big order for a retail chain and has issued an invoice of $100,000, payable in 60 days. However, FastForward needs cash more immediately to pay for raw materials for their next batch of products.
Instead of waiting for 60 days, FastForward approaches an invoice discounting company. After reviewing FastForward’s invoices and creditworthiness, the discounting company agrees to advance 85% of the invoice value.
So, FastForward receives $85,000 (85% of $100,000) upfront from the invoice discounting company, allowing them to procure raw materials and keep their production line moving.
Once the retail chain pays the full invoice amount ($100,000) at the end of the 60 days, the payment goes to the invoice discounting company.
The discounting company then releases the remaining 15% of the invoice value, or $15,000, to FastForward, but they subtract their fees and interest. If their total fee was, say, $2,000, then FastForward would receive the remaining $13,000.
Through this process, FastForward Manufacturing was able to keep their operations running smoothly without having to wait for their customer’s payment. However, they did have to pay a fee for this service.