The practice of invoice discounting is not a new method of finance in the business world. However, companies have begun to utilize this financial transaction to a greater degree in the present than they did in the past. It is essentially a form of short-term borrowing which a company uses to improve its cash flow.
In order to understand how invoice discounting works, a layman needs to grasp the somewhat indirect method through which many companies receive their payments. While most people see their money go directly into the hands of the companies from whom they buy food and supplies, when businesses work with one another money is exchanged through different means. Companies generally make large purchases from other companies and follow procedures, which sometimes take a long time to complete, before they can actually send out payment. The seller typically submits an invoice to the buyer and has to wait on payment. The copy of this invoice sits in the sellers accounts receivable and awaits payment.
Sometimes a business may be very successful in the sense that it sells a lot of good or services. However, the invoices for those transactions may sit unpaid in an office for a very long time. Meanwhile, the seller of those goods and services has been paying utility bills, servicing debt and paying employees. It is very easy, especially for a new company, to find itself completely lacking funds with which to operate in these circumstances.
This is where invoice discounting becomes useful. The company holding the unpaid invoices may choose to solve its cash flow problem by contact another company known as a factor. The factor will ask to review the accounts receivable of the company which wants to sells its invoices. After this review, the factor will offer to buy some or all of the invoices at a discount. The size of the discount varies with the factor, the invoice seller and the length of their relationship.
When the invoice seller accepts the discount, they receive the cash for the transaction almost immediately. The factor gathers the unpaid invoices and collects on them at a later date. When the factor collects, it does so for the full cost of the invoice and thereby makes a profit from the transaction.
The invoice seller actually takes a loss on the transaction. Many people see this and wonder why the invoice seller accepts less for its services than they originally charged. Such observers do not see the advantage to satisfying the present debts and maintaining the ability to continue functioning and possibly earning more business in the future.
There are options to factoring your invoices. Companies in similar situations may choose to seek a bank loan, or simply turn away new business until the invoices are paid in full. However, securing bank loans takes much more time and requires the investment of more resources than factoring requires. Turning away new business almost always spells the end for an up and coming company. That is why invoice discounting is such an attractive option.