Invoice discounting and discounting of receivable financing are often used by entrepreneurs with regards to accounts receivable. Accounts receivable, otherwise known as trade debtors or AR or A/R, is a type of working capital that refers to amounts from which management has yet to receive from their customers for goods sold. Receivables are a result of business owners extending credit to their customers.
The amount of accounts receivable is an asset on a company’s financial report but may not always match up to the amount of sales and cash inflows recorded on the company’s financial report. When small business owners find that they are cash-strapped and are unable to obtain small business loans from the banks, they sometimes turn to receivable financing such as receivables factoring and invoice discounting.
Business consultants come into the picture when clients need assistance with developing a strategy for accounts receivables management and wish to consider invoice discounting as an option of receivable financing.
What is Invoice Discounting, in Accounting Terms?
Invoice discounting is a form of short-term borrowing where the receivables are used as collateral. This method of receivable financing does not require the company to give up administrative control over its sales ledger. Invoice discounting is only available to companies which extend credit terms to its trade debtors for goods sold and services rendered.
The key difference between invoice discounting and receivables factoring is that the management has administrative control over the company’s sales ledger and also, the debtor is not made aware of the invoice discounting facility. Discounting companies typically pay cash upfront for 80 up to 90% of the company’s receivables used in invoice discounting. The cash received for the receivables depends on the age of the receivables (the older the debt, the lesser it fetches). The company pays a monthly fee to the invoice discounter and also pays interest on the net amount advanced. This is in addition to advances received or money repaid.
Once the debts are settled by the debtors, the management places the receipts from the debtors into a trust bank account. The invoice discounter will then withdraw these funds from the trust bank account and refund the management any balance amounts after net charges.
Benefits of Invoice Discounting
- The supplier is in control of the continued maintenance of the sales ledger and the collection of amounts due for payment from the debtors.
- Invoice discounting is a quick and easy way to obtain business financing (provided the debtors are reliable and the debts are not past due for too long).
- Invoice discounting reduces the costs of collections, credit control and the administration of a large department handling account receivable.
- Invoice discounting reduces credit risks for a business as a large portion of the sales are turned into cash receipts, thus reducing the risk of bad debts (the management also has the incentive to quickly monetize the receipts as he/she has to pay interest to the invoice discounter).
- It is highly confidential as the debtor is not made aware of the invoice discounting process at any juncture.
Charges and Costs of Invoice Discounting
- Invoice discounting charges including service fee and interest are based on variables such as monthly discounted amounts and the length of period it takes for an invoice to get fully paid up.
- Invoice discounting charges billed by the discounting companies which offer invoice discounting services are typically higher than the receivable financing charges by banks.
- Missing the repayment deadlines will cost the companies dearly and will mean that the companies remain in the discounting cycle for a longer period of time.
- Some invoice discounting companies have industry preferences and may charge higher for companies in certain industries. Discounting of receivables is more common in industries such as manufacturing, healthcare, transportation and telecoms. Clients in the retail and construction sectors may however find receivable financing not only harder to obtain but also pricier.
Choosing the Right Invoice Discounting Companies
Entrepreneurs can choose to either look for the invoice discounting companies themselves or hire a discount broker. In return for a fee, discount brokers who have the appropriate familiarity and connections with discounting companies can broker a good deal for the management. Whilst invoice discounting companies and invoice discount brokers are not regulated like the banks, management can find directories and more information about them at the websites for the Asset Based Finance Association and American Cash Flow Association respectively.
When management seeks out invoice discounting companies by themselves, they must take care to investigate the invoice discounting companies in the local area and negotiate the discount rates and other contractual terms.
Jo Bilson - Jo Bilson is a management consultant with interests including venture capital and entrepreneurial finance.
