Does it happen that you need urgent funds, but the payment you thought would provide you with the necessary money is still due? What do you do in such a situation? Well, bill discounting is the solution. You need to have a document equivalent to the invoice of such a trade. Sounds intriguing, right? Well, first, let's understand what is bill discounting? More on the bill discounting process later in the article.
Did you know?
Bill discounting is a trade-related activity where a company's unpaid invoices are due to be paid at a future date or sold to a financier.
What Is the Bill Discounting Definition?
In trade, bill discounting is a method through which an entity can sell its unpaid invoices (receivables) to a 3rd party financier—a bank or any other financial institution which provides the facility of bill discounting. Against the unpaid bill, the financier provides short-term aid in the working capital requirement of the entity that sold the unpaid bill and charges a specific commission and discount rate. This process of selling and getting short-term financial assistance is bill discounting. It is now the financier that further pursues the payment of the unpaid bill, not the company.
Factoring and reverse factoring are the other two methods for bill discounting designed to increase the cash in-flow in the company efficiently. They do so without disturbing the other financial statement but accomplish the same purpose as bill discounting.
Bill Discounting Rate of Interest
What exactly is the bill discounting rate of interest? Remember when we talked about a 3rd party financier providing the seller of the unpaid invoice with short-term finance. The financial institution that buys the due bill buys it at a discounted rate, which means that the amount that the company will receive against selling the unpaid bill will be less than the amount due on that invoice or bill. There is a rational reason behind this. When a company plans to opt for bill discounting to fund its requirement in the short term, it is a risk to the financial institution if that invoice has defaulted. The financial institution or any other financier buys that unpaid invoice at a lesser amount than what is on the document To keep that risk minimum or mitigate that risk.
Factors That Affect the Bill Discounting Rate of Interest
The interest rate that the financier may offer to a specific company or entity depends upon factors like business stability, financial history, economic stability, business volumes, the applicant's credit score, of the applicant or credibility of the applicant. In a nutshell, the factors depend on the company applying for the bill discounting process and with whom they are applying for the bill discounting.
Bill Discounting Process
The bill discounting process is not as complex as the concept sounds; it is easy to understand. We will also look at an example, but first, let's know the basic framework of bill discounting.
- The process enables companies to sell their unpaid invoices, which they get when they make a trade or deal with a certain set of buy or an individual buy.
- They sell these unpaid invoices to a 3rd party financier at a discounted price or a lesser value than their face value.
- The financier or discounting institution buys that particular invoice from the firm with agreeableness.
- The company then pays the amount to the company.
- After this, the financier pursues the unpaid invoice, and the buyer is supposed to pay the financier, not the company. But keep in mind that the financier will receive an amount equal to the invoice's face value.
Take a simple example of a seller (Rakesh and sons Ltd) who sold its products to a buyer (VKS Ltd). As a result, VKS Ltd gives a letter of credit from the bank of 60 days to Rakesh and sons Ltd.
If Rakesh and sons Ltd wants to get money from the bank before 60 days, the bank charges some interest rate from Rakesh and sons Ltd.
Assume that Rakesh and sons Ltd is supposed to get ₹1,00,000 after 60 days because of the bank's interest of ₹5000. Rakesh and sons Ltd receives ₹.95,000 in return from the bank. VKS ltd deposits ₹1,00,000 to the bank on the 60th day only.
Here Rakesh and sons Ltd sold its products and got paid immediately, VKS Ltd got the goods by not settling directly, and the bank earned a commission of ₹5000 on bill discounting.
Here we can see that the discounted rate of interest that the bank charges was 5%.
Below, there is an illustration of the process.
Now that we know what bill discounting is, let's understand how you can use it for your benefit.
The Criteria Of Eligibility For Bill Discounting
Depending upon the different financier or financial institution, the criteria for being eligible for bill discounting could vary. Here is a general framework that one can look up to as a guide to applying for bill discounting.
Factors that affect the eligibility
- Business vintage
- Previous loan defaults should be minimum
- The company involved in the process of bill discounting should be financially stable.
- Repayment history and capability need to be unquestionable.
- Business volume and annual turnover
- Credit rating of the business
- Business positive net worth or profitability
Now that we covered what makes a company eligible for bill discounting, let's look at the essential documents that a financier may require from the company when applying for bill discounting.
Document Required For Bill Discounting
Some key documents are required and good to have, but depending upon a financier may or may not ask for additional documents.
- Bill Of Exchange
- Commercial invoice and packing list
- Transport document i.e. (lorry receipt/ rail receipt)
- Delivery challan (fines), if any
- Acceptance from LC issuing bank
- Discounting request letter/ application
Benefits Of Bill Discounting Includes
- It helps to maintain a good In-flow of cash in the business that may be required to maintain its stability.
- It works as a quick financial aid to a company with urgent funds requirements.
- It provides instant liquidity to the company.
- No impact on the balance sheet and no debt incurred.
- The process also provides the seller of the invoice hassle-free source of finance at the expense of a small fee.
Also Read: What is TReDS?
A Few Features Of Bill Discounting Are As Follows
- Before the bill discounting transaction can happen, the banks will thoroughly check the buyer's credit history and the seller's authenticity.
- The bill discounting model involves interbank dealings. The buyer's and seller's banks discuss and agree upon the discounting terms.
We can conclude that bill discounting is a suitable short-term financing method that a company can use to meet its short-term fund requirements. We have also covered how the bill discounting process works in simpler terms. Understanding the key requirements and documents make a company eligible for bill discounting. We also learned how a third party financially earns and covers their risk in bill discounting. We discovered different bill discounting features and certain benefits that bill discounting provides to the company. Bill discounting is not limited to the banks, but the non-banking financial institutions also offer such facilities.
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