Falling short of working capital is an exporter's worst nightmare. However, if traditional financing solutions don't offer respite, the exporter can look at alternative options -- such as invoice financing.
Invoice financing is the process through which businesses arrange for funds against the amounts to be received from customers. The accounts receivable of the company is sold or attached as security to a third party, which deducts a percentage of the invoice value in exchange for the instant payment.
In a broader sense, invoice financing includes methods such as invoice factoring, invoice discounting, and receivable-based lines of credit. Exporters involved in slow payment cycles can use invoice financing to speed up the processing of their export orders and to manage their working capital position more efficiently.
Invoice financing in working capital management
Business loans and overdrafts are popular options to strengthen the working capital position of a business. However, invoice financing has its own merits compared to other options:
- Banks and financial institutions providing invoice financing services take very little time to disburse money against the invoices offered.
- Unlike loans and overdrafts, cash flow coming in through invoice financing is the business’s own money. It is not an influx of outside cash but an accelerated receipt of in-house revenue.
- By opting for invoice financing instead of a loan, exporters are also freeing up their assets that can be used later for any business loan requirements.
- Invoice financing reduces the risk of delay in receipt of payment and the efforts required in the collection of receivables.
- For businesses, invoice financing is a very flexible option for improving their working capital situation.
- Not only is invoice financing a source of quick cash with minimum documentation and delay, but it also converts debts into immediate cash, thereby reducing the waiting period and improving cash flow.
- Invoice financing is a safer option even for lenders; unlike unsecured lines of credit, it allows them to have collateral in the form of invoices.
We must also understand how invoice financing assumes significance in working capital management in the first place. In many businesses, including the export sector, customers do not make their payments at the time of purchase of goods. Instead, they buy on credit. The payment is made later at an agreed date, and the customer is presented with an invoice by the seller that indicates the payment amount and the agreed payment date. By agreeing on a future payment date, the seller sees their funds tied up, which could otherwise have been invested elsewhere.
However, by financing their invoices, sellers can manage short-term liquidity needs or simply cash in on slow-moving account receivables. Until the recovery of the payment, invoice financing remains a form of short-term borrowing, wherein the lending firm or bank releases payment based on the unpaid invoices. In the case of factoring, the exporter sells off the account receivable to the factor (the third party) and gets an immediate cash injection to rejuvenate the working capital situation.
Methods of invoice financing
- Discounting – As we saw above, discounting and factoring are popular methods of invoice financing. In discounting, the seller receives a significant portion of the invoice value from the lending firm/bank. The lender will receive the invoice as security against the immediate cash release. When the customer pays you, you can repay the lender along with their discounting charges. Alternately, the lender may directly receive the amount from the customer and release the balance invoice amount to you after deducting their discounting and other charges.
- Invoice factoring – The other common method is invoice factoring. In the case of invoice discounting, the customer may not be aware of a discounting arrangement between the seller and the bank/discounting firm. However, with factoring, the seller sells their outstanding invoices to the bank/firm, which in this case is also known as a factor. The factor will pay a significant portion of the invoice value to the seller, like discounting firms. The customer will be aware of this arrangement and will have to pay the invoice value to the factor, and not to the seller. The factor will release the remaining invoice amount after deducting factoring, collection, and other applicable charges.
- Receivable-based lines of credit – This is a credit line offered by banks and financial institutions as a percentage of the value of outstanding invoices. The value is calculated based on the age of the invoices. Accordingly, invoices whose payment dates are nearer will be subject to lower charges. The credit availed of by the seller gets reduced as and when an invoice is paid by the customer.
If you are availing of invoice financing facilities from your bank, most of your KYC and other details will be already available with them. However, in case of a first-time arrangement with a new financial institution, you should keep the following documents handy, in addition to any specific requirement they may seek:
- KYC documents for address and identity proof
- GST registration certificate and returns
- Account receivable ledgers against which finance is applied for
- Bank statements
- Financial statements
The documentation is made simple in the case of fintech companies like Drip Capital. One can submit the invoice digitally on our portal to kick-start an easy and fast bill discounting process. The need for further documentation will depend on Drip Capital’s internal assessment, which will look into factors like sales volume, growth prospects, etc.