Also known as a discounting of bill, a bill discounting is a process that involves effectively selling a bill to a bank or similar entity for an amount that is slightly less than the par value and before the maturity date associated with the bill of exchange. The debtor tenders payment to the new owner of the discounted bill in the full amount agreed upon originally. This approach allows the issuer of the bill to receive cash before the actual due date associated with the bill, while also allowing the buyer to make a modest profit on the cash advance extended to the bill’s originator.
One of the easiest ways to understand how bill discounting works is to consider a bill of exchange issued by ABC Company to its client, XYZ Company. ABC Company decides to cash in the outstanding bill in order to make use of the revenue now rather than later. To this end ABC approaches a bank with an offer to sell the bill for 90% of the par value. The bank looks over the transaction and decides the deal is viable. Upon approval, ABC receives 90% of the par value of the bill and instructs XYZ Company to remit payment to the bank. Once the bank receives full payment from XYZ, the deal is considered complete.
There are several factors that a financial institution will consider before choosing to enter into a bill discounting transaction. One has to do with the degree of risk involved with making the purchase. This will usually mean evaluating the debtor involved to determine what degree of risk exists that he or she will either settle the bill late or even default on the debt altogether. The amount of time that remains until the bill comes due is also a consideration, with institutions favoring a shorter duration between buying the instrument and receiving payment in full. Assuming the financial institution determines that the degree of risk involved is within an acceptable range, the transaction can be completed and the originator of the bill of exchange compensated with an agreed-upon percentage of the total par value of the bill.
Part of the bill discounting procedure will involve the creation of a contractual arrangement between the seller and the buyer of the commercial bill. Typically, the terms of the contract identify the percentage to be paid to the seller, and also include provisions that protect the buyer in the event that the bill is not paid according to terms. This may include the imposition of late fees or other charges, or even ultimately holding the seller liable for full payment of the bill discounting obligation if the debtor should default on the outstanding balance.