How Factoring Works?

Suppliers tend to have a significant amount of their cash tied up in accounts receivables. Hence, these suppliers often resort to bank borrowing to meet their working capital needs. Banks have been using the bills receivables that these companies have as security to make short-term loans to them. This process of making loans against future receivables is known as factoring or bills discounting.

Factoring vs. Dynamic Discounting

Corporate companies have come to realize that factoring is a waste of resources. For instance, let us assume that company A buys a product from supplier B. Now supplier B has a bill worth $100 which will be paid after sixty days. They take this bill to the bank and discount it. As a result, they get $98 today itself. Hence, $2 is paid to the bank as interest for a very short-term loan.

Instead, supplier B could have offered the company A to prepay the invoice and give them a 2% discount. The bank does not add any value since in most cases it does not assume the risk of non-payment of the invoice. It is for this reason that the world is now moving towards a new concept called dynamic discounting.

As per this concept, suppliers have the option to request payment from the buyer at any time. This is done by creating a portal whereby the supplier and buyer both have clear visibility of the invoices that have to be paid. The suppliers are then given the option to request an early payment. The discounts that they have to offer on these early payments are mapped to a sliding scale. This means that if an invoice is due in sixty days, the discount percentage will be higher as compared to an invoice that is due in seven days.

The benefit of this model is that both parties have the information required to make informed decisions about their working capital. The supplier can access early payments whereas the buyer can get bigger discounts. Both parties can gain from this arrangement. The only loser in this entire arrangement is the bank.

Factors Supporting Dynamic Discounting

The concept of dynamic discounting has been present in the academic world since the year 2010. However, it is only recently that the idea has started gaining some momentum. The major factors that have influenced the rise of dynamic discounting are as follows:

• Minimal Investment Required: The rise of dynamic discounting has led to the creation of many portals. Many of these portals allow companies to join at a very low cost. They have designed the portals in such a way that they can be integrated into the ERP systems of big corporations without major investments. Also, a lot of the suppliers are small and medium enterprises. They struggle to make huge investments in information technology. The cloud-based solutions that are being offered are proving to be a boon for these suppliers as they no longer have to rely on expensive bank factoring.
• Automation and Self Servicing: The past decade has seen an exponential rise in the automation of accounts payable processes across the industry. As a result, the manual tasks involved in the process have been brought to zero. Suppliers have increased visibility into their receivables. Dynamic discounting would have been a nightmare if the requests had to be manually processed. Now, suppliers just have to click a button. This will notify the buyer about the early payment to be made and the resultant change in the discount. Automation has made dynamic discounting a convenient process instead of an administrative nightmare.
• ERP Based Payments: Lastly, the calculation of discounts to be made at the time of payment is also a complex activity when dynamic discounting is implemented. The percentage of discount to be charged varies every day. However, since most companies process payments using ERP nowadays, this complexity can be easily imbibed into the daily operations of the firm. The rise of automatic payments has also created a favorable environment for the implementation of dynamic discounting.

Effects of Dynamic Discounting On the Banking Industry

Dynamic discounting is being adopted by many companies across the world. The number of suppliers opting for this process is doubling almost every year. The buyers and suppliers are reaping the positive benefits. However, banks all across the world are facing a negative impact.

• The decline in Deposits: Companies tend to hold their short-term deposits in the bank before payments are made. Hence, if payments are made earlier, banks start losing their deposits. Also, dynamic discounting makes the withdrawal of funds unpredictable making it difficult for banks to plan their liquidity requirements.
• Overdraft Facilities: On the other hand since suppliers get paid earlier, they do not need to use the overdraft facilities provided by these banks. Overdraft facilities are short-term and bear a high-interest rate. They are highly profitable for the banks and a reduction in their usage impacts the bottom line of several banks. Also, banks stand to lose the processing fees that they used to earn from factoring and discounting transactions.

To sum it up, dynamic discounting is rising rapidly. It is quickly becoming a norm. However, dynamic discounting can only be implemented by firms which have automated processed and technological expertise. Also, banks may need to look at other avenues to deploy their short-term funds since factoring and overdraft may soon become obsolete.