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How does Invoice Discounting work?

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Invoice Discounting: Overview

Invoice discounting is a form of short term financing source where a business is able to receive cash using as a collateral, an unpaid invoice whose due date is not past. The financier does not manage businesses’ account receivables nor collect debts on behalf of the business. In return the financier is paid a discount fee when the invoice is finally settled.

Benefits

  • Confidential agreement between Financier and Business, thus the business will continue to maintain a normal relationship with their customers.
  • Business is able to obtain cash as soon as the invoice is presented, swiftly receiving cash for much needed working capital to fund the company’s needs and growth, and providing instant access to cash tied up in outstanding invoices

Disadvantage

  • Lose a small percentage of income from the discounted invoice.
  • Not all invoices can be financed

How do you calculate invoice discounting?

invoice discounting, how does invoice discounting work, invoice discount,invoice finance

We have an example:

Business A would like to finance their company via Invoice Discounting facility

Invoice value – $10,000

Invoice date – 29 /11/2015

Obtain Invoice discounting finance – 30/11/2015 (today’s date)

Invoice due date – 30/01/2016, 61 days from Invoice discounting date

For this example, let’s say the advance rate was set and agreed at 80% and a discount rate is 1% (per 30 days)

Financier will then:

Advance cash to Business A $8,000 (80% x $10,000) on 30/11/2015

On invoice due date (30/01/2016 – 61 days later), Financier receives the invoice repayment of $10,000. Financier will then:

Deduct the discount fee of $203.33 ($10,000 * 1% / 30 * 61 = $203.33)

Return the remainder of cash – $1,796.67 ($10,000 – $8,000 – $203.33) to Business A

For Business A the Total funding cost amounts to $203.33

Technical terms

Advance rate – the % of the invoice value that Financier is willing to finance. It is usually between 70%-90% of the invoice value, depending on the quality of the invoice.

The reason that the financier usually does not advance 100% of the invoice value, is to cater for any discrepancies between the invoices value and the actual payment from the end customer. This could be ranging from; dispute, product reject/return, discount, penalties.

 

Advance value – the actual cash amount that the financier advances. .

Discount rate– the rate that Financier charges the business for the advance amount. . The rate is usually quoted per 30 day and based on the full invoice amount.

Discount fee – the final amount that the Financier charges the business for the advance amount.

Confidential agreement – The business dealings between the Financier and Business remains confidential.

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