SynopsisIf you are confused by personal finance terms, jargon and calculations, here’s a series to simplify and deconstruct these for you. In the 113th part of this series, Riju Mehta explains how this fund raising option works.INVOICE DISCOUNTINGThis is a financing practice followed by businesses to help manage their short term working capital requirements. When companies sell products and services, they issue invoices to customers. If there is a delay in payment by customers, companies use these unpaid invoices to raise funds from lending institutions. The borrowed amount is a percentage of the invoice value and lending institutions charge an interest and fee for providing this service. When customers make the due payment, the company returns the amount to the lender with interest.For instance, if a company has sold products worth Rs.1 lakh and there is a delay in client payments, the company can provide the invoices to a financier, who will pay it 80-90% of the value of the invoices, amounting to Rs.80,000-90,000. When the customers make the payment, the company repays the lender along with interest and fee.TYPES OF INVOICE DISCOUNTINGConfidential: In this case, the company keeps the entire exercise of invoice discounting confidential, without disclosing it to customers. It raises funds from the lender and settles the amount after its customers make the payment, without the latter being aware of the entire process.Disclosed: As the term suggests, here the customers are aware of the company’s arrangement with the lending institution for raising funds by using the invoices. Whole turnover: This is when a company uses almost its entire sales ledger or a large volume of its invoices to raise funds from a lender.Selective: As opposed to the whole turnover, selective invoice discounting involves picking a section of the sales ledger for raising funds. The invoices can be selected on the basis of their value, payment terms, etc.Before you continue readingHow financially free are you?Most people overestimate their financial freedom. Discover your Financial Freedom score through a quick surveyBENEFITSCash flow: The company can generate funds instantly through invoice discounting instead of waiting for customer payments, which can follow a 30-90-day cycle.No collateral: The business doesn’t need to keep property or equipment as collateral with the financial institution to raise funds.Easier than loan: It’s a simple, uncomplicated process to generate cash, where the amount is disbursed much faster than in case of a business loan.DRAWBACKSCharges: Generating instant funds comes at a cost for the company, with the high fees and interest charged by the lender eating into its profit margin and impacting its performance. Liability: Even if the customer does not pay for the products or services, it is the company’s responsibility to repay the lender in the stipulated time, while also chasing the client for payment.Not easy for small firms: Smaller firms are not preferred by lenders. The practice works better for larger firms as they have high turnovers and stronger credit profiles, which makes them attractive among lenders (Join our ETWealth WhatsApp channel for all the latest updates)...more