Unsettled invoices can hinder the frequency of receiving funds to maintain the cash flow. This is an especially major constraint for the MSME sector as 60 percent of SMEs in India receive payments from clients after 60 days or longer.
Businesses cannot afford to wait until the buyer releases payment; they need funds to continue operating their business. This is where innovative financing tools of bill discounting and bill purchase come into the picture.
What is Bill Discounting and Why is it Used?
A bill discounting solution is used to address cash flow issues caused due to waiting for bills to be cleared. It involves receiving a short-term loan from banks or financial institutions against unpaid invoices.
Banks deduct a certain discounting fee from the total invoice amount before crediting the amount to the seller or exporter. The seller now has sufficient funds to meet their working capital needs.
The credit control and responsibility to collect payment from the buyer remains with the sellers.
The bill discounting process helps businesses maintain working capital requirements through such short-term financial assistance where the unpaid invoices are kept as collateral against the loan.
Once the importer or buyer completes the payment to the seller, they can repay the loan to the financial institution.
Bill Discounting Process
Suppose Company A has sold products worth ₹1,00,000 to their customer Company B. Company B cannot complete the payment immediately and promises to pay after two months of purchase.
Company A needs the cash sooner than two months for various expenses such as raw material, salaries, etc., and approaches a financial institution to apply for a short-term loan against the unpaid invoice. The finance company offers the loan at an interest rate of, say, 10% per annum. They also deduct ₹5000 from the total amount as discounting fee and deposit ₹95,000 into the account of Company A.
Following is the step-by-step process of bill discounting:
Company A supplies goods worth ₹1,00,000 to Company B and creates an invoice for the same. Company B accepts the invoice and promises to make the payment on the due date set at two months from the date of purchase. Company A approaches a financial institution to receive a short-term loan against the unpaid invoice of Customer B.
After verifying the creditworthiness of the buyer, i.e. Company B and the validity of the invoice, the financial institution deposits the invoice amount minus the discount charges into Company A’s account i.e. ₹1,00,000 - ₹5,000 = ₹95,000.
Company A receives ₹95,000 from the lending institution, which they can now allocate for procuring raw materials to fulfill more orders, disbursing salaries, or any other activities to expand their business.
At the end of the credit period of 2 months, Company B makes the payment to Company A, allowing them to repay the loan of ₹95,000 to the financial institution.
What are Bill Purchases?
Bill purchase or invoice factoring is a financing service that helps manage cash flow issues for long credit periods. It involves selling unpaid invoices to third-party institutions called factors for a cash advance at a discounted rate against the total invoice value.
A significant change from the bill discounting process is that in bill purchase, the credit control and responsibility of collecting dues from buyers fall to the factors or lending institutions.
In this process, the customers are aware that the sellers have used a third party to raise funds against their invoices.
Bill Purchases Process
Suppose Company X has trade receivables of ₹2,00,000 and approaches a lending institution or factor to sell these trade receivables because they are in need of immediate cash to continue business operations.
The ABC finance company buys the trade receivables from Company X and provides them 80% of the total invoice amount, which is ₹1,60,000. Following is the step-by-step process of bill purchase:
Company X has ₹2,00,000 worth of trade receivables, i.e. total amount billed to customers for which they have not received payment yet. Company X sells the unpaid invoices to the factor ABC finance company. ABC company analyzes the invoices and provides 80% of the total value i.e. ₹1,60,000 as a cash advance to Company X.
The right and responsibility to collect the payment is transferred to ABC company.
ABC initiates the payment collection process. When the customers clear the payment, ABC deposits the remaining 20% to Company X after deducting interest charges or service fees.
How are Bill Purchases and Bill Discounting Different?
Both bill purchase and bill discounting solutions provide access to instant capital to manage business funding gaps. Even though the process for both the financing tools seems similar, there is a fine line of difference between the two.
Bill Purchase vs Bill Discounting: Which is Better?
The purpose of bill discounting and bill purchase is to provide instant financing without any collateral so that businesses can manage their cash flows.
When deciding which financing option to go for, businesses should consider the following factors:
Customer Relationship
In bill discounting, the duty of collecting pending payments from the customers lies with the seller.
The customers don’t have to be aware if the seller uses the bill discounting method, and there is lesser scope for affecting the customer relationship.
On the other hand, bill purchase involves transferring the responsibility of payment collection to the lender or factor. Therefore, the buyer has to be informed when opting for this financing option.
Since the payment responsibility and right over the dues is with the factor, the relationship between seller and customer might get negatively affected.
Collection of Dues
If a business can benefit from the expertise of a lending institution for collecting dues, then they can opt for bill purchase for effective payment collection. If the business wants to retain responsibility for payment collection and already has an effective process in place for it, then they can opt for bill discounting.
Enterprises that do not have an efficient payment collection process and need assistance in its implementation will have to consider the trade-off between keeping customer relationships intact and streamlining their cash flows.
Ultimately, the selection of bill discounting or bill purchase depends on the needs and strengths of individual businesses.
