Bill discounting is a financial instrument which allows buyers to procure goods or services and sellers to raise capital against invoice bills. It plays a crucial role in international trade, and often many reputed buyers use this method to purchase goods or services from international sellers.
Banks lend the seller capital in exchange for the invoice in this financial process. However, the banks also charge fees for this process, and the seller gets fewer amounts issued in the bill. Let’s learn how bill discounting works and the advantages and disadvantages of this financial instrument.
- Bill Discounting is a financing option available to businesses where they can sell their unpaid bills to a third-party financial institution at a discounted price to get immediate cash flow.
- This process helps businesses to manage their working capital and meet their short-term financial needs.
- The third-party financial institution then collects the bill amount from the business’s customers at the full price, earning a profit on the discount given.
How does it work?
When a business runs low on cash, it uses the bill discounting method to pay its seller or supplier. For example, in a business transaction, a seller, Jon, sells $10,000 of goods to a buyer Sam. But currently, Sam doesn’t have the money.
Fortunately, he will have the money in the next 2 months. So, Sam writes a bill in Jon’s favour so that he can draw the money from him on a certain date after 2 months. Now, Jon needs capital for his regular business expenses. He can deposit the bill to a bank and raise capital against it. After two months, the bank will draw the money from Sam.
Banks do not do this task for free. All banks charge fees for procedures. In the financial world, many people call it Bill Discounting or Invoice Discounting. In the financial transaction process, the seller gets fewer amounts, which was mentioned in the bill. Banks take this amount as fees for facilitating the transaction. In this process, the maturity date of the invoice plays a crucial role. Banks charge extra for the extended bill maturity date. Many banks only offer this facility to reputed individuals and companies.
Advantages of Bill Discounting
Multiple advantages come with the bill discounting process. It allows the buyer to procure goods or services against bills or invoices. It also allows the seller to raise essential capital when needed and increase the capital flow to the business. On the other hand, banks also gain profit by facilitating this financial process.
This process gives flexibility to the seller for doing business. The seller also doesn’t need to knock buyer’s door for payment. Instead, the bank takes care of this task. Overall, this process strengthens the business relationship and easily makes complex trading possible.
Disadvantages of Bill Discounting
Bill discounting is not a complete business solution, and a few disadvantages are associated with it. Most banks offer bill discounting processes to reputed business individuals and companies only. For this reason, small businesses cannot take benefit of this facility.
Banks also increase their charges with a prolonged bill maturity date, which can substantially reduce the billed amount. The bill or the invoice is a legal obligation the buyer must pay at the given time. Failing to pay the amount on a given day can have serious consequences. In such cases, the bank can sue the buyer and take appropriate legal action against the buyer.
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.