Invoice discounting vs traditional borrowing

Whether a startup or a profitable entity, most businesses can face a cash crunch. Lack of smooth flow of funds affects the long-term growth of the business. To meet its working capital requirements, a business needs to opt for short-term financing. Popular short-term financing methods are invoice discounting, invoice factoring, bank loans, etc.

Understanding invoice discounting and its benefits

Invoice discounting is a type of short-term invoice financing method. The business takes a short-term loan from the financial institution against its unpaid invoices. The financing company charges a discounting fee ranging from 1%-3% of the total invoice value along with service charges. On maturity of the invoice, the business itself is responsible for payment collection. It will then repay the loan amount to the financial institution.

Benefits:

1. Full control over its sales ledger: The financial institution just provides a loan against outstanding invoices and does not have any control over the sales ledger of the business entity.
2. Less expensive: This method is less costly than traditional business loans and invoice factoring. There are no add on loan processing charges or fees.
3. Easy availability: The government has taken the initiative to build a marketplace for availing invoice discounting facilities such as TReDs. This ensures the extension of benefits to the wider market.
4. Maintains confidentiality: The customer is not in the loop anywhere in this type of finance. They make the payment directly to the business entity. They are unaware of the liquidity crunch faced by the vendor entity. This helps to build customer trust.

Understanding traditional borrowing and its uses

The traditional and the most widely used method of financing is a bank loan. There are various types of bank loans available in the market based on the loan term and collateral required to obtain the loan. Depending upon the cost, a business entity can choose to avail the loan.

A business entity must keep certain points in mind while taking a bank loan:

1. It involves unexpected expenses such as taking insurance, license, etc.
2. The business needs to have a long-term marketing plan.
3. It involves processing charges.
4. It requires business projections.
5. Any delay or non-payment is reported to CIBIL, which impacts the business’s credit score.

Short-term loans and working capital loans are available to meet the liquidity crunch of the business. But, the lock-in period usually ranges from 12-24 months. 

Uses:

Bank loans are used to meet the working capital requirements such as payment to vendors, salary, other operating expenses, etc.

Comparison between invoice discounting and business loans

Invoice discounting	Business loans
It can be quickly processed in a couple of days.	It involves lengthy processing time.
No collateral is required. It is issued against unpaid invoices.	It requires collateral.
Interest is paid on the actual amount required as funds are released against unpaid invoices.	Interest has to be paid on the entire amount of the loan.
The tenure ranges from 30-90 days.	The loan tenure is long.
The discounting charges are less as compared to business loans.	It involves incurring high loan processing charges.
It is available on unpaid invoices. It does not impact the Balance Sheet.	It gets reported in the Balance Sheet as a Borrowing.
The business entity decides the loan requirement and produces invoices worth it.	The bank finally decides the amount to be disbursed even though you apply for a higher amount.

Invoice discounting or traditional borrowing – Which is better?

Invoice discounting does not add liabilities to the company’s balance sheet. Thus, there is no increase in the debt of the company. This method of invoice financing is quick and hassle-free. There are no strict rules for how long the business has been running. Here, invoices serve as an assurance for repayment as no other collateral is required. Additionally, the loan tenure is short, usually 30-90 days.

On the other hand, bank loans require collateral. The tenure is long. The loan processing formalities are time-consuming, and bank charges are high. 

Thus, we can say that invoice discounting is a quick and easy way to avail short-term loans.