Companies looking to improve their working capital are turning to invoice discounting. Discounting is widely known to improve a company’s cash flow position, but it is also thought of as expensive. This article will discuss some advantages and disadvantages to this type of financing.
Before we delve into the pros and cons of discounting invoices, let’s talk about how it works. There are several different types of discounting agreements, but the one most commonly used in the United States is when a company uses its receivables as collateral. A company forms an agreement with a bank or other financial institution. This institution will usually allow the company to borrow up to 80 or 90 percent of the face value of the loan. The amount that can be borrowed depends on the credit-worthiness of the company’s customers. Usually the company will still collect the money from its customers and then it will pay down its loan with the bank (note that this is different than a Factoring agreement where the bank or financial institution collects the money from the customers). Usually with these agreements come with a service charge of anywhere from one to three percent. In addition there is usually an interest charge that is usually quite above the risk free rate.
Advantages of Discounting
The obvious advantage is that your company gets capital right away. This is especially important for growing companies.
Your company will know when you are getting cash. This really helps for budgeting, planning, and purchasing purposes.
Your company only pays interest on the amount you decide to borrow, as opposed to factoring where you end up selling the entire amount of your receivable.
Discounting is usually considered confidential (hence the name, confidential invoice discounting). This means that your customers don’t know you are using their receivables to finance your business, with factoring they know because the Factor is collecting their payments.
Disadvantages of Discounting
This method of financing is more expensive than a traditional bank loan. Note that this method might be less expensive than other forms of financing (like offering a two percent discount to customers for early payment).
Companies can come to rely on this form of financing their business. Most companies don’t want to be in a discounting relationship forever.
May look bad to your suppliers. In some situations discounting is taken as a sign of weakness. If your suppliers don’t think you can make your payments, then they may not offer you good credit deals.
That sums up our discussion on the pros and cons of invoice discounting. This can be an excellent way to improve your cash flow situation in the short run, but it is probably a bit too expensive to continue over the long haul.
