Difference Between Bill Discounting and Bill Purchasing by Banks
Banks offer various financial services to support businesses in managing their cash flows. Two such services are bill discounting and bill purchasing. Both aim to provide businesses with immediate liquidity, but they differ in their mechanisms, costs, and risks. Here, we will explore the details of each method and their key differences.
Bill Discounting
Definition: Bill discounting is a financial service where a bank provides immediate cash to a business by purchasing its bills of exchange, such as promissory notes, at a discounted rate before their maturity date.
Mechanism:
- A business issues a bill of exchange to a debtor buyer.
- The business approaches a bank to discount this bill.
- The bank pays the business the face value of the bill minus a discount interest for the remaining period until maturity.
- The bank then collects the full amount from the debtor when the bill matures.
Purpose: This method helps businesses obtain immediate working capital without waiting for the debtor to pay the bill on its due date.
Risk: The risk of default primarily lies with the bank since it is responsible for collecting the amount from the debtor.
Bill Purchasing
Definition: Bill purchasing involves a bank buying a bill of exchange outright from a business at face value, providing funds to the business immediately.
Mechanism:
- Similar to bill discounting, a business has a bill of exchange.
- Instead of discounting, the bank purchases the bill at face value.
- The bank assumes the right to collect the full amount from the debtor at maturity.
Purpose: This service is used when a business needs cash flow but does not want to discount the bill. It can be beneficial for the bank as it receives the full payment upon maturity.
Risk: The bank takes on the risk of the debtor defaulting on payment at maturity, similar to bill discounting.
Key Differences
AspectBill DiscountingBill Purchasing Cash FlowProvides cash at a discountProvides cash at full value CostInvolves a discount interestNo discount, bank pays face value RiskBank assumes collection riskBank assumes collection risk Use CaseImmediate liquidity needFull value needed upfrontConclusion
Both bill discounting and bill purchasing are essential tools for businesses to manage cash flow effectively. The choice between the two depends on the specific financial needs and strategies of the business. Understanding these differences can help businesses make informed decisions on how to secure the liquidity they need to operate smoothly in the market.