What is Invoice Discounting?
Invoice discounting is a traditional form of transactional finance used to shorten cash conversion cycles for companies. Under this arrangement, the company sells its invoices at a discount to invoice buyers in exchange for an upfront advance.
Cash crunches can put a dampener on revenue growth and allows inefficiencies to creep into the business. For instance if customers keep paying late, then there may be insufficient working capital to purchase and process inventory needed to fulfill your next sale order. This problem plagues small-to-medium medium sized enterprises (SMEs) and multi-national corporations (MNCs) alike.
Most invoice discounting programmes are documented as ‘true sale’ transactions. In other words, it is structured as a deal between the Invoice Buyer (banks and non-bank financial institutions) and the Invoice Seller (the company).
Invoice Discounting Money Flows
After terms of the invoice discounting programme are agreed,
- Invoice Buyer agrees to purchase invoices from the Invoice Seller at a discount to face value. Invoice Buyer remits an initial advance to Invoice Seller.
- Eventually when the Invoice Seller’s end customer pays full value for that invoice, the residual amount (face value less initial advance) would then be made to the Invoice Seller.
Fees and charges as agreed in the termsheet are built into both legs of the transaction.
Structuring an Invoice Discounting Program
There are various features for potential Invoice Sellers to be aware of before entering into invoice discounting programmes:
- Notified discounting – Invoice Seller’s customers acknowledge that invoices payable by them have been sold to the Invoice Buyer
- Non-notified discounting – Invoice Seller’s customers are not informed of the invoice discounting programme
- Spot factoring – Allows Invoice Seller to selectively factor on an invoice-by-invoice basis
- Initial advance percentage – The upfront advance the Invoice Seller receives (typically 75% and above, but never 100%)
- Discount charge – Commonly expressed as a flat rate % per month, or a base rate (USD Libor/USD Prime) + credit margin per annum
- Fees – Common costs layered into the transaction include upfront fees, processing fees and annual review fees
- Securities and guarantees – Assignment of receivables and shareholder/director personal guarantees for full recourse invoice discounting
- End customer sub-limits – Dollar limits placed on invoices by end customer based on transaction history or project size and tenor
- Controlled account – For non-notified factoring, monies from the end customer would be remitted into a bank account registered under the Invoice Seller’s name, but in effect controlled by the Invoice Buyer
- Trade credit insurance – Invoice Buyer may be required to be listed as a co-insured or loss payee under any trade credit insurance policies
- Balance sheet treatment – For Invoice Sellers who are concerned about the treatment of invoice discounting, it would be advisable to clarify the accounting treatment prior to entering into the programme
When Things Go Wrong
Defaults can occur due to problems with the underlying transaction between Invoice Seller and its end customer:
- Set-offs – End customer offsets amounts from Seller’s invoices for raw materials the former had sold to the Invoice Seller but not yet received
- Double-financing – Same invoice was used financed by two or more Invoice Buyers, whereas payment would only come from one end buyer
- Lost control over controlled account – Invoice Seller removed Invoice Buyer’s ability to block payments out of the controlled account
- Forgery or fraud
As far as Invoice Sellers are concerned, we have seen end customers terminating its supplier-customer relationship with Invoice Sellers as a result of the additional hassle of having to deal with the Invoice Buyers’ requests. On the flip side, we have also seen Invoice Sellers being able to scale their businesses quicker with the help of invoice discounting.