Invoice discounting involves selling an invoice to a bank for slightly less than the face value before the due date, allowing the biller to receive cash early and the buyer to make a profit. The financial institution evaluates the degree of risk involved before entering into a transaction and creates a contractual agreement between the seller and buyer.
Also known as invoice discounting, invoice discounting is a process that involves the actual sale of an invoice to a bank or similar entity for slightly less than the face value and before the due date associated with the bill of exchange. The debtor presents payment to the new owner of the discounted invoice for the full amount initially agreed. This approach allows the biller to receive cash before the actual due date associated with the bill, while allowing the buyer to make a modest profit on the cash advance extended to the biller.
One of the easiest ways to understand how invoice discounting works is to look at a promissory note issued by ABC Company to its client, XYZ Company. ABC Company decides to collect the outstanding invoice in order to use the revenue now rather than later. To this end ABC approaches a bank with an offer to sell the account for 90% of the face value. The bank reviews the transaction and decides that the deal is viable. Upon approval, ABC receives 90% of the invoice face value and instructs Company XYZ to send the payment to the bank. Once the bank receives full payment from XYZ, the deal is considered complete.
There are several factors that a financial institution will consider before choosing to enter into a bill discounting transaction. One has to do with the degree of risk involved in the purchase. This usually means evaluating the debtor involved to determine what degree of risk there is that he or she will settle the bill late or even default on the debt. The amount of time left before the bill is due is also a factor to consider, with lenders favoring a shorter duration between purchasing the instrument and receiving payment in full. Assuming the financial institution determines that the degree of risk involved is within an acceptable range, the transaction can be completed and the initiator of the bill compensated an agreed percentage of the total face value of the bill.
Part of the invoice discounting process involves creating a contractual agreement between the seller and the buyer of the commercial invoice. Typically, the terms of the contract identify the percentage to be paid to the seller and also include provisions that protect the buyer if the invoice is not paid according to the terms. This may include the imposition of late fees or other charges, or even ultimately, the seller’s liability to pay in full the obligation to update the invoice should the debtor default on the outstanding balance.
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