Bill discounting, or invoice financing is a short-term finance option for businesses, which can help them free up funds tied up in unpaid invoices. As a result, companies can optimise their cash flows and payment cycles without disturbing their balance sheets.
It offers advantages to vendors and purchasers alike. Vendors can fuel growth and stabilise operations in a cost-effective way. On the other hand, customers gain from improved negotiations with vendors and suppliers and an optimised raw material supply.
As a case in point, the growth numbers on one of the Trade Receivables Discounting System (TReDs) platforms licensed by the Reserve Bank of India (RBI) for invoice discounting are a testament to the benefits and popularity of invoice discounting:
As per reports, M1xchange surpassed Rs 1 lakh crore in throughput (business volume) in May 2024. With a 100 per cent year-on-year growth, the company said it discounted invoices worth Rs 43,000 crores in FY24.
This blog post focuses on best practices for evaluating invoice discounting requests to ensure it remains a win-win for all stakeholders.
How Bill Discounting Works: A Quick Overview
As noted above, the bill discounting option allows a business to access funds instantly without waiting for the due date. Here’s a snapshot of the process:
- Sale of Outstanding Debts: The business sells its unpaid invoices (accounts receivables) to a lender or financial institution (FI) at a discounted price.
- Immediate Payment: The FI provides the business with an upfront payment, minus a commission or discount.
- Debt Collection: The FI takes responsibility for collecting the outstanding amount from the customers on the due date.
- Discount Rate: The discount charged by the FI depends on factors such as the customer’s creditworthiness, the business’s volume, and the payment terms of the invoices.
Bill Discounting: Some Risks to Watch Out for
However, invoice discounting, like any lending process, comes with inherent risks, such as:
- Non-Payment: The most significant risk is that the buyer of the goods/services might not pay the due amount to the financial institution.
- Customer Credit Risk: Your customers’ creditworthiness is crucial. If your customer base has a history of delayed payments or defaults, it increases the risk for the lender.
- Hidden Costs: Some bill discounting agreements might include hidden fees or charges that could increase the overall cost of borrowing.
- Loss of Control: Once you’ve sold the bill, you lose some control over the collection process. The financial institution might adopt collection practices that could strain your relationship with the customer.
- Cash Flow Dependency: While bill discounting offers immediate cash, it can create a dependency on this form of financing for ongoing operations.
- Eligibility Criteria: Not all bills are eligible for discounting. Factors like the creditworthiness of your customers and the industry you operate in play a role.
Key Strategies to Lower the Risks of Bill Discounting
FIs can help protect themselves and reduce risk by following eight basic guidelines, which we discuss below.
1. Make a Thorough Credit Assessment
Lenders should execute a thorough credit assessment before accepting a bill discounting request. Reviewing the supplier’s and buyer’s credit history and assessing their credit ratings provides the lender with a fair view of the credit health of both stakeholders.
Analysing the financial statements also provides a deeper view of their financial health and ability to meet their financial obligations. Choosing clients with a good credit history and robust financial statements mitigates the risk of default.
2. Verify the Authenticity of the Bill
Lenders can safeguard themselves against fraud by verifying the authenticity of a bill. To ascertain the reliability of the transaction, they should ensure that the invoice is original and not a photocopy or a digital copy.
Comparing the invoice with the original purchase order and matching the invoice with the corresponding delivery receipts or bills can be helpful.
3. Keep a Close Eye on Client Payment Behaviour
Financers must monitor client’s payment behaviour and track delays or late payments. Staying vigilant can help pick any signs of cash flow challenges, and the lender can take the required steps to prevent minor challenges from growing into larger problems.
FIs can protect their interests through proactive action and monitoring of client’s payment patterns. Monitoring and reviewing invoice discounting portfolios and procedures help identify emerging risks and inefficiencies.
4. Make a Comprehensive Risk Assessment
Lenders can protect themselves by making an exhaustive risk assessment when they evaluate a bill discounting request. They should factor in the risk associated with the industry in which the buyer and supplier operate.
FIs must also assess the overall economic conditions that may impact operations or the ability to pay. They should also know the legal and regulatory changes affecting business operations or transactions.
5. Diversify Your Client Base
Dependence on a single client or a small group of clients raises vulnerability and credit risk for the lenders. FIs can counter this by diversifying their portfolio; having clients from different industries and ensuring that their portfolio is not heavily skewed toward a single company.
Diversification protects against over-reliance on a particular sector or businesses and helps lenders have a more resilient and flexible business model. Lenders can navigate economic fluctuations and potential challenges better with a diversified portfolio.
6. Set Smart Credit Limits
Lenders should set appropriate credit limits for all clients to minimise risk exposure. They should set credit limits for each client based on their creditworthiness and past payment behaviour.
A dynamic and adaptive approach to setting credit limits in bill discounting involves considering various risk factors in real time. This approach ensures efficient credit exposure management.
7. Consider Invoice Insurance
Invoice insurance can shield lenders from the noon-payment risk involved in bill discounting. The insurance helps mitigate the financial impact of unpaid invoices and safeguards against potential losses.
8. Embrace Emerging Technology
Embracing technology in their bill discounting process can help lenders streamline their operations, improve efficiency and mitigate risk.
Tools that leverage Artificial Intelligence(AI) can help lenders stay protected from fraudulent activities by analysing patterns and historical and identifying outliers. For example, the Document Identifier extracts relevant information, saves time, and reduces human-induced errors in the onboarding process.
On the other hand, data analytics helps lenders comply with regulations related to anti-money laundering and the Know Your Customer (KYC) process and address compliance-related issues
To Sum It Up
Bill discounting offers a hassle-free way for businesses to finance their short-term financial needs. Financial institutions keep themselves safe and minimise the chances of fraud and non-payment by taking a few basic measures.
Accurate credit health assessment, verifying the bill authenticity, monitoring the portfolio, using modern technology, and setting smart credit limits are a few past practices that lenders can adopt.
As a Lending Lifecycle Management and Credit Evaluation Services platform, Finezza offers solutions for lenders that can help them incorporate bill discounting best practices in their operations and manage their processes better. Its comprehensive analytics suite, leveraging Machine Learning and Big Data analytics, helps manage all the stages of the process.
To learn more, contact us today!
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