“The three most dreaded words in the English language are ‘negative cash flow’.” David Tang
As anyone who’s ever had bills to pay would know, striking the correct balance in what cash comes in and what goes out is essential to survival. Every business incurs hundreds of expenses to run efficiently: from staff salaries, to the electricity bill, or even new coffee bags for the coffee machine. If this steady outflow is not matched by those wonderful credit SMS notifications in your account, the business has to either cut expenses or look for alternative short-term and long-term funding options.
In fact, according to a Genpact study, right at this moment, some 7–12% of combined revenue in working capital is “stuck” somewhere in outstanding receivables in organizations all over the world.
This translates to over US$1–2 trillion lying idle, and not being reinvested for growth.
Here’s a quick comparison for you. Most companies spend 25% of their efforts in collecting from customers, while best-in-class businesses spend less than 5%. This 20% difference translates to millions in savings over the lifetime of the organization.
For small and medium businesses, it is important to stay competitive and offer their customers attractive lines of credit, where the Accounts Receivable (AR) cycle can often exceed 30, 60 or even 90 days.
This leads to a sudden and unplanned shortfall in working capital which can cripple business operations and bring your company to its knees. This is where invoice factoring can give a business easy access to working capital essential for its daily operations and survival.
One of the fastest and easiest ways to offset the adverse effects of AR on your cash flows is by selling your invoices at a discounted rate to an invoice factoring company (also called a factor). In return for this, the factor provides the working capital that your business can use for its daily expenditures. This is called Invoice Factoring, sometimes also referred to as Invoice Discounting or Bill Discounting.
It is a form of unsecured financing since it does not ask SMEs to provide any collateral as guarantee. This is an extremely attractive proposition for SMEs who may not be eligible for a loan from traditional financial institutions like banks.
Any entity in the business of selling goods generates invoices in the name of its customers or buyers, also specifying the terms of payment and the line of credit in the invoice. The seller then submits such invoices to a factoring company (factor) who buys these invoices and pays anything between 70–90% of the invoice amount upfront to the seller. Here's an example of how Invoice Factoring works in an Import/Export business.
The initial application process often involves the factoring company performing background checks on the credit history of applicants' customers or buyers, to ensure that they have the capability of paying the invoice amount. The application process can take anywhere between 1-2 weeks and is a one-time requirement.
Once the credit period is reached, the factor collects the payment from the buyer of the goods, reducing the hassle of the seller. The factoring company receives the total outstanding invoice amount from the buyer, and then pays the remaining 10–30% of the original discounted invoice amount back to the seller of the goods. The factoring company or factor charges a fee for this service and the cost of financing depends on various factors such as the financial strength of the buyer, type of goods, political or economic stability of the market, etc.
Factoring companies typically offer two kinds of invoice factor lending: Recourse and Non-Recourse (Limited).
Recourse: This is a kind of invoice factoring in which if the buyer of the goods does not pay the invoice dues, then the seller is liable to buy the defaulted invoices from the factoring company. Thus the factor will not face any losses due to the customer’s non-payment of the invoices. The discounting rate for recourse lending is often lower than non-recourse lending as there is no risk factor associated for the factor company due to a customer’s non-payment of dues.
Limited or Non-Recourse: In this option, if the invoice dues are not paid by the buyer for reasons such as bankruptcy, then the seller is not liable to pay money to the factor company. Here, the risk for the factor company is much more than the recourse method of lending because it will face losses if the buyer fails to pay up. Thus, the discount rate for purchase of invoices will be much higher since the risk involved is higher. In case of any quality or commercial dispute, recourse is back to the seller of the goods.
A business loses some amount of money in invoice factoring, since they sell the invoices at a discount to the factoring company. This is the amount of money they would have otherwise received if their buyer paid upfront during the time of purchase of the products. However, this is a small fee to pay compared to the advantages that invoice factoring offers:
Increased Cash Flow: The single most important benefit of invoice factoring for SMEs is increase in the working capital to meet their daily cash flow needs.
No Bank Loans: SMEs face many challenges while seeking loans from traditional financial institutions such as banks due to various reasons such as credit history, collateral requirement, age of business, etc. Invoice factoring eliminates the need to accrue bank loans at a higher interest rate.
Early Access to Working Capital: Getting a loan from a financial institution could take as much as 30 days or more, with extensive paperwork and other processes involved. Factoring companies, however, have a very simple online application process which takes only 5-10 minutes. The factoring application can get approved as early as within seven days. Once the application is approved, the first instalment of the capital is available within 24 hours, directly in the seller's bank account.
Smooth Collection Process: Generally, factoring companies have a wider operational footprint with far more efficient payment collection methods than small and medium businesses. As a result of this, they need not worry about the money they are owed.
Focus on Business Expansion: As the SME does not have to invest valuable resources in tracking customer payments, they can fully focus on using the entire cash flow to expand their business locally or globally.
Nothing is completely foolproof and risk-free when hard-earned money is involved, and invoice factoring is no exception to this. There are a few risks involved, and while they may be minimal, it is important for SMEs to be aware of them:
Customer Refuses to Pay: The biggest risk in any transaction of goods is if the buyer refuses to pay the invoice amount to the seller for any reason. In such cases, the SME may incur monetary losses if it has a recourse factoring agreement with the factor. Thus, it is in the SME’s best interests that they do a thorough background verification of their customer's credit history prior to any transaction.
High Transaction Fees: If the SME has a poor credit score, chances are that the factoring company may charge a higher-than-normal interest rate. This, when compounded with a one-time service fee, may give a significant blow to the overall cash flow of the SME.
Souring of Customer Relationship: Factor companies, in most cases, directly collect the payment from the SME’s customers. If, for any reason, the relationship between the customer and factor turns sour, it could adversely affect the customer-SME relationship as well, as no business would like to lose their customers.
The most important factor for any invoice factoring company is to understand the market of the SMEs they are lending to and ensure that they have a deep knowledge base of the SMEs' target market. This knowledge includes not only market data or credit history, but also contingent factors like the cultural practices in the customer’s country. This is to ensure that the factor never ruins the relationship with the SME’s customer due to miscommunication. After all, the SME’s customers are as important to the business of the factor as they are to the SME.
Choosing the right invoice factoring company for your business will depend on services and facilities you need. Do want to factor all your invoices, or only a few select few? What about risk -- in case the customer doesn't pay up on the invoice, are you willing to take on the payment? These and other factors will influence the invoice factoring company you choose, such as the type of financing offered (recourse vs non-recourse), the terms and rates offered, the industries the factors work with, any hidden costs, etc.
Choosing the right invoice factoring company thus is a crucial decision, and Drip Capital is perfectly positioned to help you make this decision.
You can make use of our easy invoice factoring processes to unblock your working capital and not worry about your outstanding receivables.
Drip Capital has financed over $100 million of trade across export domains in multiple industries including garment and textiles, processed/packaged & frozen food, engineering products, agro commodities, etc. in the last two years in India alone. So apply now to turn your invoices into cash and push forward your business growth.