Capital for Capitalists: Invoice Discounting

6

Invoice discounting is a methodology where a company's trade receivables are used as collateral for getting short term loans. Now, this is a very convenient process where the large sellers get their payments early. Let us understand this with the help of an example. 

Number of daysNumber of ordersSale price Cost of the productProfitTotal Profit
301100901010
602100901020
903100901030
1204100901040
1505100901050
1806100901060
2107100901070
2408100901080
2709100901090
3001120018020110
3301320018020130
3601520018020150

In the given chart standard credit period is of  30 days which means the supplier receives his payment after 30 days and thus the supplier is able to have a total of 15 payment cycles and thus 15 orders within a year, also at the end of 9th month the accumulated profit happens to be of 90 after which the supplier is able to execute 2 cycles per month. ( see the second chart below) 

Number of daysNumber of ordersSale priceCost of the product ProfitTotal Profit
51999099
1029990918
1539990927
204 99 90936
2559990945
3069990954
3579990963
4089990972
4599990981
50109990990
551219818018108
601419818018126
651619818018144
701819818018162

Now when an invoice discounting firm comes into the picture instead of 30 days the supplier will receive the payment within  5 days but the discounting firm will pay somewhat less to the supplier say 1 percent less, here we will observe that within a span of just 50 days the supplier has accumulated profit of 90 same as we saw in the previous example where this was achieved after 9 months.


HOW THIS WORKS?

In this process, the seller sends goods or services to the buyer who happens to be big MNCs. The invoice is then confirmed by the MNCs. This invoice is then discounted with the help of invoice discounting firms. The credit period would have been 30 days but these firms will say make payment to sellers after just 5 days with a slight reduction say of 1 percent. 

HOW IS THIS DIFFERENT FROM BANK LOAN?

Banks also provide working capital loans but the rate of interest is quite high which is not feasible for most enterprises.

BENEFITS FOR THE SELLERS

  • Availability of funds within a short span of time.
  • Collateral free working capital loans are available.
  • Deploying funds increase the growth prospects of the company.
  • Low risk as the invoice is selected from authentic buyers.

TYPES OF INVOICE DISCOUNTING

Confidential invoice discounting- the process remains the same here just the fact that the buyer is not aware that the invoice has been discounted. This adds a sense of reliability to the sellers for the buyers.

Confidential invoice discounting with an escrow account- we just add an extra layer of security where the payment is being made to an escrow account which then transfers the amount to the discounting firms.

Self invoice discount- this is the most common technique where if the buyer pays immediately gets a discount of say 2 percent and after 30 days will have to make full payment. 

Crowdfunding- herein, a large pool is created and then this pool is used for discounting.  The two most popular crowdfunding platforms are KredX and Trade credit. 

RISKS INVOLVED 

Needless to say, invoice discounting being a very lucrative resort carries with it two major risks.


1. CREDIT RISK- What if the buyer doesn't pay. 

  • It is the risk of default by the paying party. 
  • Risk assessment is required to lower this risk
  • Understanding the financial health of the buyer ( if listed low risk)
  • The credit rating of short term debts ( by credit rating agencies)
  • Historical patterns of payments deployed 


2. DURATION RISK- higher the duration of payment higher the risk of default

  • If the payments have to be received from the same buyer within 30 days and 60 days there is more uncertainty in 60 days. 

  • In order to lower duration risk, invoices of the lower span should be selected. 

WHAT IS IN FOR YOU TO TAKE?

Crowdfunding is a platform where small investors like us can easily invest their money and avail numerous benefits:
  • Short payment cycle so there is liquidity
  • A diversified portfolio of invoice ( say you have 5 lakhs to invest, instead of investing in the same invoice 1 lakh each can be invested in 5 different invoices )
  • Minimal risk as the invoice are authenticated ( complete authentication of buyers and sellers)
  • High returns compared to other asset classes
  • There is a risk analysis system to safeguard the interest of investors.
I hope it was helpful 
-Articulated By Divya Pansari

Other Article by the author: What is prompt corrective action?


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Disclosures and Disclaimer

This article is being furnished for informational purposes only. We make every effort to use reliable & comprehensive information, but we do not represent that the contents of the article are accurate or complete.

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