Discount of receivables: Overview, definition, and example
What is discount of receivables?
Discount of receivables refers to the process by which a business sells its accounts receivable (money owed by customers) to a third party, such as a factoring company, at a reduced price. This discount allows the business to receive immediate cash, rather than waiting for the customer to pay the debt. The discount represents the fee charged by the buyer of the receivables for taking on the risk of collecting the debt and the time value of money.
For example, a business might have $100,000 in outstanding invoices from customers but needs cash now. They may sell those receivables to a factoring company for $90,000, allowing them to access $90,000 immediately rather than waiting for the full payment.
Why is discount of receivables important?
Discounting receivables is important because it allows businesses to improve cash flow, particularly when they face urgent financial needs or when customers have long payment terms. It enables companies to access funds immediately rather than waiting for payments, which can help with operational expenses, payroll, or other investments. For businesses that need liquidity, the ability to discount receivables can be a useful financial tool.
For the buyer of the receivables, it offers the potential to collect the full amount of the receivable at a profit. However, the buyer assumes the risk of non-payment by customers.
Understanding discount of receivables through an example
Imagine a company has issued $50,000 worth of invoices that are due in 90 days. However, the company needs cash now to cover payroll. The company sells those receivables to a factoring company at a 10% discount, receiving $45,000 in cash immediately. The factoring company will then collect the full $50,000 from the customers over the next 90 days, making a profit of $5,000 from the discount.
In another example, a small business might decide to discount receivables to take advantage of a time-sensitive opportunity, such as a bulk purchase discount from a supplier, allowing them to buy goods at a lower price by using the cash generated from the sale of their receivables.
An example of a discount of receivables clause
Here’s how a discount of receivables clause might appear in a contract:
“The Seller agrees to sell, and the Buyer agrees to purchase, all outstanding receivables of the Seller at a discount of 5% from the face value of the receivables. Payment for the receivables will be made immediately upon transfer of ownership of the invoices.”
Conclusion
Discounting receivables is a financing option that allows businesses to access immediate cash by selling their outstanding invoices at a reduced price. This practice is useful for companies needing liquidity quickly, though it involves a cost in the form of the discount. By selling receivables, businesses can improve cash flow and continue operations without waiting for customers to pay, while the buyer of the receivables assumes the risk of collecting the full debt.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.