Invoice discounting is a technique or a process by which a company can borrow cash from financial institutions on the basis of the invoices raised. In other words, invoice discounting is more of a short-term borrowing; where a company can draw cash against the invoices.
In Invoice discounting the company is liable to collect payments from its customers. Generally, a company can borrow up to 80% of the invoice amount within 24 hours. The actual percentage and duration may vary with different finance institutions and banks. This is very widely used by companies for immediate cash requirements and is one of the working capital sources.
It is important to know the advantages and disadvantages of the Invoice discounting technique in order to use it effectively.
Advantages of Invoice Discounting
Invoice discounting is comparatively quicker and faster method to procure cash than applying for a Cash Credit in which credit institutions or banks take quite a lot of time in credit appraisal of the borrower.
Releases Locked Cash
Invoice discounting releases cash that has been locked in customer invoices for a long period of time. Invoice discounting converts the company’s account receivable (debtors) into liquid cash. This may even be useful in cases or emergencies.
Improves Cash Flow
Invoice discounting provides improved cash flow since generally 80% of the advance invoice amount (receivable) can be converted into cash thereby aiding shorter working capital cycles.
No Asset as Collateral
Cash can be obtained without using any assets as collateral; only invoices to which customers are yet to pay are to be submitted for the transaction.
Allows More Room for Credit Sales
The company can choose to grow sales in terms of cash or credit. Sales that are on credit can be converted into cash quickly and the company need not bother much about the liquidity issue which comes with credit sales if invoice discounting process is in place.
In the case of invoice discounting, confidentiality can be maintained by the discounting houses. The suppliers and customers need not know about the borrowings of the company against sales invoices.
Win-Win Situation in Business
The borrowing company can obtain the cash it needs whereas the customer can be given the credit period. This creates a win-win situation for the company and the company’s customer which in turn helps in building a healthy relationship with customers.
Disadvantages of Invoice Discounting
Decreases Profit Margins
The financial institutions providing invoice discounting generally charge a fee which becomes an additional cost to the company. This decreases the profit margins for the borrowing company.
Some people perceive invoice discounting as a stigma over the company, hence, excessive reliance on invoice discounting may not be taken very positively by all stakeholders.
Only Commercial Invoices
The majority of financial institutions allow borrowing only on commercial invoices. If a company deals with general public then that company may not be eligible for invoice discounting.
Leniency in Credit Terms Affecting Productivity
Excessive usage of invoice discounting facility may cause management to be non-focussed on strengthening credit norms for debtors. The company should ideally be focussing on shorter credit periods and not invoice discounting as a mechanism to improve working capital cycles and liquidity.
Invoice discounting is a quick method to improve cash flow and working capital cycle but one has to keep in mind that invoice discounting should be used as an additional facility and not as a regular process. The key focus should be on improving working capital cycle by bargaining efficiently with debtors to ensure quick payments.