Invoice Discounting Vs Supply Chain Financing

By Ram - Dec 27 2023

Companies have various financing options available to them, each with its advantages and disadvantages. Two of the commonly preferred methods are supply chain financing and invoice discounting.

These innovative financing methods let companies access credit without impacting their credit score. But there’s more to these financing options that companies need to consider before settling on any option to help them decide which financing method best serves their needs.

What is Invoice Discounting?

First up is invoice discounting. This type of short-term financing allows businesses to borrow money against the value of their outstanding invoices. Under this arrangement, the business will work with a lending institution to secure funding, which can be used to cover operational expenses or other debts.

Invoice discounting gives the business an effective way to manage cash flow and improve financial flexibility. Still, it is important to understand the risks involved before agreeing. One thing to remember with invoice discounting is that the financing company charges a fee for each transaction and may buy A/R at discounted rates.

Pros Invoice Discounting

Some of the benefits associated with invoice discounting include;

  • You get quick access to capital – Invoice discounting often gives businesses quick access to funds. The process requires less paperwork than other business loan types and is more accessible to business owners to get approved for these loans. Cash can be transferred directly into your business account.
  • Improved credit control – Invoice discounting provides an additional layer of credit control measures on behalf of the business to ensure your customers can pay the invoices. These measures also reduce risk for businesses by ensuring they deal with customers with good credit. This is particularly crucial for small businesses that don’t have functional and staffed credit and collection departments.

Cons of Invoice Discounting

As beneficial as invoice discounting might be, it has its downsides. Some of the ones to consider include;

  • A/R is treated as collateral – Invoice discounting provides you with early invoice payments but as liquid assets. To access the facility, you must borrow against your unpaid invoices, leading them to be used as collateral.
  • You will not receive the full amount of an outstanding account – Most A/R financing companies will not give you the full amount of the invoice. As a rule, you can get up to 80% of the value of the invoice as an advance payment. The balance is sent to you in the second instalment when the customer pays the invoice, net of any [additional days] fee incurred.

How It Works

Invoice discounting allows companies to use their unpaid invoices as collateral to secure funding. You don’t need real estate collateral or a long trading history to access this type of funding.

Unlike supply chain finance, this financial arrangement is made between the supplier and the invoice financing company and doesn’t usually involve the buyer at all.  It’s flexible and can be adjusted and customised to your company’s needs, size and objectives.

How it Helps

Invoice discounting allows businesses to access cash owed to them sooner. This can free up disruptions in cash flow cycles, allow the business’s ongoing operations and enable long-term growth and success.

Common Misconceptions

Some myths about the invoice financing sector, some more pervasive than others, might confuse business owners when looking through the different financing methods. Invoice financing has been around for quite some time but still is not fully understood by all businesses.

You are required to finance every invoice

This is not true, especially with Key Factors. You don’t need to finance all invoices or your entire accounts receivable. As a flexible financing solution, businesses get to choose the invoices they want to utilise depending on their needs.

At Key Factors, we offer selective invoice financing, which allows you to choose the invoices you want to submit for financing and when you want to submit them. Businesses often match the size of the invoices they want to finance to their needs.

Invoice discounting constricts you with a long-term contract

It is true that some providers might stick you with long-term contracts. However, there are many options when it comes to choosing an invoice finance provider. Others, like Key Factors, offer flexible funding solutions with no lock-in contracts that allow businesses to come and go depending on their financial requirements.

You can choose the number of invoices you want to finance and how long you want to use the facility with no questions asked.

It’s for struggling businesses only

This is the biggest myth as far as invoice financing is concerned. Cash flow gaps are a reality for struggling, growing, and successful businesses.

An expanding business can often experience cash flow gaps due to extended payment terms. Invoice financing helps to plug these gaps, ensure smoother cash flow, and increase liquidity without tying the company down to long-term debt.

Invoice discounting releases the funds already owed to your business. It’s not the same as a business loan obtained by companies trying to stay afloat financially.

What is Supply Chain Financing?

Supply chain financing is slightly more technical but is still an equally useful business tool. It gives small businesses an opportunity to extend payment dates to suppliers without impacting their cash flow, and the suppliers don’t lose money.

When using supply chain financing, the supplier receives an advance payment on the outstanding invoices from a third-party funder. When the payment date comes for the small business a few weeks later, the business fulfils the payment, and the money goes to the funder or supplier, depending on which holds the account at the time.

Like invoice financing, this is not a loan. It is a business tool that small businesses and suppliers can use to free up capital. It is typically offered by banks and other financial institutions. The institution offering the funding may charge a fee for each transaction, and this is not an asset-based lending program.

Pros of Supply Chain Financing

Here are some of the benefits that make SCF an excellent financing choice for your business;

  • It’s not an asset-based lending program – Supply chain financing is not a debt or a loan. It involves a direct relationship with a third-party funder to fund early payments of invoices for the business. Although the funding institution can charge a fee, no debts or penalties are associated with it.
  • It’s a fast way to free up cash – if your business is in need of quick cash, financing allows you to receive funds faster because invoices are being paid in advance. Faster payments allow the business to use the cash quickly.

Cons of Supply Chain Financing

On the flip side, supply chain financing has the following downsides;

  • There are fees involved – It shouldn’t come as a surprise that the third-party funder attaches a fee to the services. That means the business may lose a small portion of its income through financing. The third-party funder and/or supplier receives early payment with a small fee attached for this service. Usually, supply chain financing is provided for large corporations.

How it Works

In supply chain finance, a buyer of goods or services will work with a third-party finance institution to pay the invoices owed to the suppliers upfront. In exchange for their invoices’ early payments, the supplier discounts the amount owed. This approach to financing is also called reverse factoring.

How it helps

Supply chain factoring can be an excellent way to free up working capital that would otherwise be held up in unpaid invoices. The additional working capital can be used to take advantage of growth opportunities, cover operating costs, purchase new equipment and provide funds for any other re-investments in the business.

Supply chain factoring can benefit the buyer as well. They get to retain the cash payable to the supplier for longer without being pressured to pay within the strict term limits that restrict their ability to operate and grow. SCF is a great facility for larger businesses to support their smaller suppliers.

Common Misconceptions

SCF is growing in popularity among businesses in Australia over the last few years. Although more businesses know about it now, there are still misconceptions about this financing option.

It’s only suitable for large companies

Although supply chain factoring is often preferred by large corporations, it’s not only designed for them. The service has evolved over the years and is more accessible to businesses. Most supply chain financing providers used to be traditional banks that focused on large corporations.

Currently, with innovation and technology, other third-party institutions have come in and focused their services on small businesses, making it a viable option for SMEs as well. It allows smaller companies to improve cash flow and strengthen their supply chain.

Suppliers have to extend their payment terms

Supply chain financing adds a third party to the agreement between the supplier and the buyer. However, that does not mean the supplier must alter their existing net payment terms.

It simply provides flexibility for the buyer to pay for the goods and services at a later point while ensuring the supplier receives the payment early. The finance company covers the upfront payment to the supplier, and the buyer pays the finance company when the invoice is due.

This benefits both parties in the transaction and consequently strengthens the entire supply chain.

Supply chain finance isn’t a reliable form of funding

Supply chain finance isn’t well understood and is often considered less reliable than other forms of traditional business financing. However, recent occurrences have shown that supply chain financing is as reliable as any other conventional funding solution.

Banks and other financial institutions have become more risk-averse and are implementing stricter lending requirements; supply chain finance providers have increased funding to businesses of all sizes.

Supply Chain and Invoice Finance: Key Differences

Choosing between either form of financing requires a deep understanding of how each works. If you’re still not certain about which of these two financing options best serves your business, perhaps highlighting the differences between the two options can help shed more light.

Structure

Invoice financing involves a business selling its outstanding invoices to a financial institution as a third party and getting a percentage of the invoices’ value upfront.

On the other hand, supply chain finance doesn’t involve the buyer. Instead, it’s an arrangement between the supplier and the financial institution providing early payments.

Scope

Invoice finance unlocks capital tied up in outstanding invoices, primarily benefiting the business by providing them with the funds upfront.

Supply chain finance benefits the supply chain by facilitating early payments for the suppliers while giving the buyer extended payment terms. It’s a win-win for the supplier and the business.

Terms

Invoice finance aligns with the original payment terms between the buyer and the supplier, while the supply chain offers extended terms for the buyer and allows them earlier payments for the suppliers.

Approval criteria

Invoice finance requires the worthiness of the supplier to be assessed and approved. In contrast, supply chain finance requires the creditworthiness of the supplier’s buyers or customers to be assessed and approved.

These differences should make it easier for the business to choose which options are ideal for them based on the nature of their business and their financial situation.

Closing Remarks

Businesses certainly have more financing options now than they had in the past. While the variety makes it easier for businesses to pick and choose their financing partners, it’s also vital for the business to choose the right financing method.

Supply chain finance and invoice finance are similar yet different in many ways. In invoice finance, the business fronts its account receivables for upfront cash, while the supply chain pays suppliers earlier, so the business has more time to pay its invoices. To make the right choice, the business must consider its position and financial obligation and determine which methods best serve its needs.

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