What is Invoice Discounting? (Advantages and Disadvantage)

Invoice discounting is when the business uses an unpaid invoice from customers or a balance of the accounts receivables as collateral to obtain the loan from the lenders. It enables the business to remain operational when it does not have sufficient working capital to continue its activities.

This type of financing is specifically valuable for the business that has to stick their funds in the receivables and wait for a long time to receive the payment. It’s the same concept as financing with factoring.

However, the customer does not know that the business has obtained financing against their balance in invoice discounting. Further, receivables remain in control of the business, the same as in the case of normal business processes.

Hence, this process is effective and efficient in helping the businesses without affecting normal operations. Although, the business getting finance may have to compromise on the profits. But, if the business’s profitability is higher, there may not be a massive financial impact.

However, it’s important to note that it may not be a long-term solution to arrange the financing as it does cost money for the business seeking finance.

Advantages of invoice discounting.

Following are some of the advantages of invoice discounting.

1) Improved flexibility

The size of finance to be obtained is flexible and dependent on the balance to be received. It means if your balance tied in the accounts receivables is higher, you’ll be able to receive a higher amount of the loan and vice versa. Hence, the flexibility of invoice discounting is flexible enough to meet the business demand and maintain the liquidity of the capital.

2) Improved cash flow

The companies with invoice discounting do not have to face a scarcity of cash resources. These businesses can even avail the cash discounts offered by their suppliers. Further, raising the finance with the invoice discounting is fast and can lead to enhanced efficiency of the business operations.

However, invoice discounting only helps to enhance the cash flow in the short term. So, the businesses must consider other sources of finance to plan the long-term working capital management.

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3) Faster growth

Businesses with immediate access to working capital can more efficiently operate and run the operations. This enables the business to operate effectively and grow without much hustle of financing. In other words, invoice discounting encourages credit sales and adds to the growth of the business exponentially.

4) Confidentiality

The financing with the invoice discounting ensure confidentiality. The customer does not get to know that their balance of payable has been used as collateral. Hence, it helps to maintain the business terms between the business obtaining finance and the customer.

5) Minimal risk

The risk associated with invoice discounting is minimal because the business does not have to provide revenue-generating assets as collateral. In fact, it’s just about management of the working capital as cash received now has to be paid later once accounts receivable is realized.

Disadvantage of invoice discounting.

Following are some of the disadvantages associated with invoice discounting.

1) Higher volatility

The amount to be raised under invoice discounting is limited to partial or full funding of the account receivable balance. So, the business may not be able to raise a specific amount of their desire. Hence, there is enhanced volatility, and financing needs may not be completely fulfilled.

2) Commercial invoices only

From an investor’s point of view, invoice discounting is a risky mode of lending. Hence, it cannot be a viable mode of financing that deals with the general public in credit. So, to limit their risk, the lenders only count commercial invoices for granting the finance.

3) Cost element

It’s important to note that the business has to incur a processing fee and the cost of interest on the invoice discounting. Further, the cost of interest may be higher on this type of funding than traditional financing sources, which may reduce the net profit of the business.

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4) Sentiments of the stakeholders

Suppose the business has a trend of raising finance with invoice discounting. Instead of improving credit policies and financial forecast, it relies on invoice discounting. Hence, it might hurt the sentiments of the stakeholders about managing the capabilities of the company.

It might indicate that management is not capable of handling the working capital efficiently. Instead of improving the credit management function, they have to incur expenses to manage the operations.

When the business should opt for invoice discounting

The invoice discounting works best when the business has a higher gross profit. The reason is that higher gross profit has the potential to absorb the interest cost associated with it. In this case, obtaining fast cash can speed up the credit sales and lead to overall growth and development of the business.

On the other hand, exercising invoice discounting may lead to lower profits and even a loss if the business has smaller profitability. So, a strong financial analysis needs to be done before deciding the source of finance.

Invoice discounting from lender’s perspective

Invoice discounting seems to be a beneficial deal for the lenders. Although it’s said to be an unsecured loan, the lender has the right to receive the funds once they are collected. Further, the lender approves an amount less than the invoice. Hence, the risk of the lender is limited.

However, the lender’s risk is that if the customer never pays the invoice, it might be difficult to collect the balance. Although, this risk can be minimized by only approving financing for the commercial invoices as their chances of default are low.

Bottom line

Invoice discounting is when the business raises finance from lenders by giving this balance as collateral. It’s valuable for a business that has higher profitability and looking for fast cash. This mode of financing offers a flexible approach to manage the working capital.

Further, procedural formalities for this financing are comparatively less stringent and can be completed with less time.

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Another greater advantage of this financing model is confidentiality. The business customer does not know that their payable balance has been given as collateral because it retains the control on payable management.

However, there are some drawbacks too for opting for this source of finance. These include a higher cost of financing which means the business has to pay more interest as lenders perceive this investment as a risky one.

Similarly, some stakeholders might perceive this financing as management’s incompetence. It’s because they should improve their credit control policies instead of relying on short-term and expensive sources of finance.          

Frequently asked questions

What’s the difference between invoice discounting and invoice factoring?

An invoice discounting is when the business raises finance by giving receivable balance as collateral. Although, the basic theme of invoice factoring is the same as invoice discounting. However, the difference is that in invoice discounting—the power to control the receivable remains with the business.

Is it good to opt for invoice discounting?

It depends on the nature of the business and related operations. If the business has higher profitability, it may pay the cost and processing fee and interest. So, it may be good for their growth and expansion. However, if profitability is lower, it may not be a good idea.

Why is invoice discounting considered an expensive mode of financing?

Invoice discounting is considered expensive because the cost of processing and interest is higher than traditional sources of finance.

What are the instant features of invoice discounting?

Following are the factors of invoice discounting.

  1. Fast cash availability
  2. Confidentiality
  3. Higher cost
  4. Improved cash flow
  5. No collateral required
  6. Retained control of the receivables
  7. Flexible financing

What are the requirements for invoice discounting?

You need to have a balance of the accounts receivable in the balance sheet. Further, the lenders usually accept commercial invoices only. So, the invoice raised for the general public does not qualify for the loan.