Invoice Factoring: A new lease of life for SMEs

“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 salaries of the staff, to the electricity bill, or even new coffee bags for the coffee machine.

If this steady outflow is not met with 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 SMEs, it is important to stay competitive and provide their customers with attractive lines of credit, where the Account Receivable (AR) cycle can often exceed 30, 60 or even 90 days.

This leads to a shortfall in working capital and and can cripple operations and bring your company to its knees. This is where invoice factoring can give you a fresh lease of life.

Invoice Factoring

One of the fastest ways to offset the adverse effects of AR on your cash flows is to turn to rapidly growing fintech companies who are willing to buy your AR invoices at discounted rates. In return for this, they provide the vital funds your company requires for its daily expenditures. This is called Invoice Factoring.

It is a form of unsecured lending since it does not ask the SMEs to provide any collateral. This is an extremely attractive proposition for SMEs who are not eligible for a loan from traditional financial institutions like banks.

The company which provides the funds to the SME is called the factor. Once an SME sells products to its customers, it generates invoices in the name of its customers specifying the terms of payment and the line of credit. The factor company buys these invoices from the SME and decides to pay anything between 70–85 % of the invoice amount upfront, once the SME’s application is approved.

Often this process will involve the factor company performing a background research on the credit history of the SME’s customers to ensure that they have the capability of paying the invoice amount.

The factor buys these invoices at a discounted price from the SME. The factor then collects the money from the buyer, reducing the hassle of the SME. Once the factoring company receives the total invoice payment from the customer, it will pay the outstanding 15–30 % of the original discounted price to the SME. For this service, the factoring company will charge a fee.

Types of Factoring

Factoring companies offer two kinds of invoice factor lending: Recourse and Non-Recourse (Limited).

• Recourse: This is a kind of invoice factor lending in which if the customer does not pay the invoice dues, the SME is liable to buy the defaulted invoices from the factor company. Thus the factor company will not face any losses due to the customer’s non-payment of the invoices. The discount price 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 dues are not paid by the customer in case of default or bankruptcy, the SME 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 customer fails to pay up. Thus, the discount price 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 SME

Benefits of Invoice Factoring

SMEs lose some amount of money in invoice factoring, since they sell the invoices at a discount to the factor company. This is the amount of money they would have otherwise received if the customers paid upfront during the time of purchase of the products. However, this is a small price to pay in lieu of the huge benefits that invoice factoring offers to SMEs.

• Increased cash flow: The whole point of invoice factoring is for SMEs to increase their working capital to achieve their business objectives.
• No bank loans: SMEs face a huge disadvantage while seeking loans from traditional financial institutions such as banks due to poor credit history. Invoice factoring eliminates the need to accrue bank loans at a high interest rate.
• Early availability of funds: Procuring a loan from a financial institution could take as much as 30 days or more, with extensive paperwork and other processes involved. Factoring institutions, however, have a very simple online application process. The application hardly takes 10 minutes on average. The application can get approved as early as within seven days. Once the application is funded, the first instalment of the funds is available within 24 hours. These funds are also not bank loans with interest.
• Smooth collection process: Generally, factoring companies are big global organizations with far more efficient payment collection methods than SMEs. As a result of this, SMEs 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 in expanding their business interests.

Risks involved in Invoice Factoring

Nothing is completely foolproof and risk-free when hard-earned capital and money is involved, and invoice factoring is no exception. There are a few risks involved, and while they may be minimal, it is important for SMEs to be cognizant 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 myriad reason. In these cases, the SME may have 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 history, chances are that the factor company may charge a high transaction fee. This, when compounded with the discounted prices and a one-time service fees, may add up to 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 sours, this could adversely affect the customer-SME relationship as well, as no business would like to lose their customers.

The time is ripe for you to give your SME productivity a boost!

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 SME’s 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.

This is where Drip Capital is perfectly positioned to help you

You can make use of our easy invoice factoring processes to unblock your working capital and not worry about your outstanding receivables.

We have financed over $100 million of trade across export domains in four industries — Garment and Textiles, Processed/Packaged & Frozen Food, Engineering Products, and Agro Commodities — in the last two years. Sign up to leverage our relationships, experience, knowledge and credibility to help you push forward your business growth.

Don’t let lack of money get in the way of your growth!

About Drip Capital

Drip Capital is a trade finance company headquartered in California, USA. We offer finance to Indian exporters selling to buyers in North America, Europe, Middle East and the Asia Pacific. Established in 2014, Drip Capital has built a strong presence across India having financed hundreds of shipments across industries such as textiles and garments, packaged and frozen foods, metals and engineering goods. With a focus on SMEs, we have provided our clients timely access to working capital and helped them grow their exports by as much as 60% in less than a year.

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