Receivables Discounting: What It Is and How It Works

Receivables discounting allows businesses to access cash from unpaid invoices by selling them to a third-party financial institution at a reduced price. This strategy accelerates cash flow, providing immediate funds that would otherwise be tied up for 30 to 90 days. This method converts a company’s credit sales into ready capital, helping to manage operational expenses and fund growth without waiting for standard payment cycles.

The Mechanics of Discounting Receivables

The process of discounting receivables involves three participants: the business owed money, its customer, and the financial institution that buys the receivable. It begins when the business issues an invoice to its customer. Needing cash sooner than the invoice’s due date, the business approaches a financial institution, often called a factor, to sell the unpaid invoice. The factor provides a percentage of the invoice’s value upfront, between 75% and 90%.

An important aspect of these arrangements is the assignment of risk, defined by whether the transaction is “with recourse” or “without recourse.” In a “with recourse” agreement, the business selling the invoice retains the risk if its customer fails to pay. Should the customer default, the business is obligated to buy back the receivable or replace it. This structure results in lower fees because the lender’s risk is minimized.

Conversely, a “without recourse” transaction transfers the credit risk of non-payment to the financial institution. If the customer does not pay the invoice due to financial inability, the factor absorbs the loss. Because the factor assumes a higher level of risk, the fees and discount rate for this financing are higher. The process concludes when the customer pays the invoice, and the factor remits any remaining balance to the business after deducting its fees.

Calculating Discounting Fees and Proceeds

The cash a business receives from discounting its receivables is the face value of the invoices minus the lender’s fees. These fees are the lender’s compensation for providing immediate cash and for taking on associated risk. The primary cost is the discount fee, calculated as a percentage of the invoice’s total value, and ranges from 1% to 5% depending on customer creditworthiness and payment term length.

To illustrate, consider a business with a $20,000 invoice due in 60 days that enters a discounting agreement with a financial institution charging a discount rate of 1.5% per 30 days. The total discount fee for the 60-day period would be 3%, or $600. If the lender also charges a one-time processing fee of $150, the total cost for the business would be $750. The net proceeds the business would receive is the face value of the invoice less these total costs, meaning the business would get $19,250 in immediate cash.

Accounting Treatment for Discounted Receivables

The accounting for discounted receivables is dictated by whether the agreement is with or without recourse. These differences determine how the transaction is recorded on financial statements. Generally Accepted Accounting Principles (GAAP) distinguish between a true sale of an asset and a collateralized borrowing.

When receivables are discounted “without recourse,” the transaction is treated as a sale of assets because the business has transferred the risks and rewards of ownership. The journal entry involves a debit to Cash for the proceeds, a debit to Discounting Expense for the fee, and a credit to Accounts Receivable to remove the invoice from the books. This treatment improves the seller’s balance sheet by converting a receivable into cash without creating a new liability.

In a “with recourse” scenario where the seller retains control, the transaction is accounted for as a secured borrowing. The journal entry would be a debit to Cash for the funds received and a debit to Interest Expense for the lender’s fee. Instead of crediting Accounts Receivable, the business credits a liability account, such as Notes Payable. The Accounts Receivable account remains on the balance sheet, and a corresponding liability is created, reflecting the obligation to the lender if the customer defaults.

Information Required by Lenders

Before a financial institution agrees to discount receivables, it conducts due diligence. To facilitate this risk assessment, the business must provide a comprehensive package of documents. Key requirements include:

• The business’s registration documents and recent bank statements
• An accounts receivable aging report, which details all outstanding invoices and how long they have been outstanding
• Financial statements for the last two to three years, such as income statements and balance sheets
• The business’s credit history to assess its track record of managing debt
• Information about the customers whose invoices are being discounted, including their payment histories
• Copies of the specific invoices the business wishes to discount, as these serve as the legal basis for the debt

The Application and Funding Process

After compiling the necessary documentation, the formal application process begins. This involves submitting the complete package through the lender’s online portal or to a representative. This submission starts the lender’s underwriting and due diligence period, which can take from a few days to a couple of weeks.

During this time, the lender verifies the invoices and assesses the credit risk. If approved, the lender issues a formal agreement outlining the terms, including the advance rate, discount fees, and recourse provisions. The business must review and sign this agreement to proceed.

After the agreement is executed, the business can submit invoices for funding. The lender transfers the advanced cash, 75% to 90% of the invoice value, into the business’s bank account. This funding can occur within 24 to 72 hours of submission. The process is completed when the end customer pays the invoice, and the lender settles the remaining balance with the business after deducting its fees.