What is Bill Discounting procedure? How does it work? These are two questions that we will answer in this blog post.
We will define the Discounting procedure, advantages, disadvantages, and other details. Keep reading to learn more!
What is Discounting procedure?
The Discounting procedure is a financial tool that allows businesses to borrow money at a discount. The Discounting procedure works by enabling companies to sell their accounts receivable (invoices) to a third party for less than the face value of the invoices.
This third party is known as a Discounting company. The Discounting company will then purchase the invoices from the Discounting company and pay you a discounted value for them.
Technically discounting procedure is when the vendor sells the bill to the addressed company for a lesser value than the actual invoice amount before the due date.
The difference is made in the amount paid, and the discounting company earns the bill value. The fee will vary based on the time before the due date and the expected risk.
Invoice Discounting = Bill amount – Amount paid
Who will get benefit from discounting procedure?
Both vendor and buyer will get benefit from discounting procedure.
Because of the discounting procedure, the vendors will get the money as soon as possible, which helps them make more cash that can be further utilized for the business.
The vendor sells the goods to the purchaser and issues an invoice as agreed by both parties. The buyer verifies and acknowledges to clear the invoice before the agreed due date.
The seller then contacts the discounting company and scrutinizes the credibility of the seller and the validity of the submitted invoice.
Once it gains the confidence to go ahead, the discounting company will release the cash to the seller with a negotiated margin that depends on several factors. Then, finally, the vendor gets the fund and uses it as per their choice.
With the arrival of the due date of payment, the discounting company will produce the invoice to the buyer and collects the money for their transaction.
Even though discounting procedure helps bring immediate cash to the sellers, it is expensive compared to bank overdrafts.
However, with several brokers and financial institutions encouraging this system, it is advantageous for the sellers to get cash in dire situations where other options are unavailable and uncertain.
Example of discounting procedure
Assume that company A (vendor) sold its products to company B (buyer). As a result, company B gives a letter of credit from the bank of 30 days to company A.
If company A wants to get money from the bank before 30 days, the bank charges some interest rate from company A.
Assume that company A is supposed to get $100,000 after 30days because of the bank’s interest of $5000. Company A receives $.95,000 in return from the bank. Company B deposits $.100,000 to the bank on the 30th day only.
Here company A sold its products and also got paid immediately, company B got the goods by not settling directly, and the bank earned a commission of $5000 on invoice discounting.
This process of the discounting procedure is called invoice discounting or Bill discounting.
Two ways of presenting the invoice
- With resource: The vendor’s bank verifies and checks all the documents and discount terms and then sends them to the buyer’s bank. Then the buyer’s bank does not check the other things, and it can claim to reimburse later on if any issue is there.
- Without resource: The vendor’s bank does not check any documents during the time of request for the payment, but the buyer’s bank checks all the documents.
Advantages of Discounting
Boosts cash flow: As soon as an invoice is issued, you get cash immediately. This cash can be used to invest in the business. This way allows you to boost your cash flow and start your business.
Free ups locked cash: It avoids blocking money in customer invoices for a long time.
A quick way to get loans: It helps to reduce the time taken for the invoice to convert cash. Once your invoice financing partner trusts you, you can automatically reduce the collection period of your invoices by submitting those invoices for invoice discounting.
Not required assets: No need to submit your company assets to the bank. The banks only require the account receivables as surety.
Disadvantages of Discounting
Reduced Profits: It reduces the profit on invoices that have been financed. That is a short-term service. The discount covers interest charges, administrative charges, and maintenance charges.
The percentage of discounts also differs from one banker to another. So the vendor who sells the goods has to lose some percentage of bill value.
Limited discount bills: All bills can not be discounted. Invoice discounting is usually offered only for commercial bills because of the risk involved for the banker.
Why do we need discounting?
We need discounting because, by considering the time value of money, the value of a dollar today is more than the value of the dollar tomorrow. So discounting is essential in evaluating future cash flow.
What is discounted cash flow?
Discounted cash flow is an evaluation technique that allows you to evaluate the value of an investment drawn on its expected cash flow.
Analysis of discounted cash flow helps determine the value of today’s financing, based on forecasting how much money it will create in the future.
Calculation of discounted cash flow includes the following procedures.
- Calculation of financial statement procedure
- Calculation of free cash flow
- Calculation of discount rate
- Calculation of terminal cash flow
- Finding the final value
If you’re interested in using the Discounting procedure, you’ll need to find Discounting companies willing to purchase your invoices at a discount.
It is not without its risks, however. One of the most significant risks is that you may not be able to find Discounting company that is willing for Discounted sale of your accounts receivable (invoices). Additionally, it can hurt your credit score if it’s not used correctly.
Hoping you found this information helpful!