In the last couple of decades, businesses have started using non-traditional financing methods when they are in need of immediate funds. Invoice discounting is one such popular financing alternative where businesses use their customer invoices as collateral to access loans from financing companies.
The promises of quick cash and flexibility are real, but as with other forms of financing, employing new financing tools without proper knowledge is a recipe for disaster.
Here are some of the major risks involved with invoice discounting and how a company could mitigate them:
Credit risk – A seller could have a dispute with its customer during the invoicing period and they might refuse to honour their dues. This would trap the seller organisation in a situation where you have already received the money from the discounting company, but its customer isn’t paying. This might create legal consequences for the seller organisation as it owns the responsibility to collect the payment from its customers. Credit risk can be mitigated by having strong collection mechanisms like eNACH, auto-debit mandates, doing reverse factoring, etc.
Hidden cost – Invoice discounting might cost the borrower a lot if you don’t check the agreement and guidelines thoroughly or pick the right discounting company. These hidden costs might include administrative fees, proposal fees, application fees, credit checking fees, due diligence fees, schedule processing fees, notification fees, etc. They might be hidden in the fine print of the agreement, so read your agreement carefully before signing up.
Operational risk – These risks are the risk that originates from the invoice itself. If the seller organisation is struggling to get its invoices paid on time and experiencing lengthy delays, errors in the invoice, invoice rejected by the buyer due to quality issues, etc. Operational risks can be mitigated by having a robust invoice validation mechanism – e.g. only ERP accepted invoices allowed for discounting, system to mark out invoices that have been financed, GST system based validation, etc.
Lack of diversification – If a seller relies excessively on a single client, it could be a major risk. Invoice discounting works best when a business has unpaid invoices from a variety of debtors. This could put your business in a vulnerable situation and it might fail if the invoice discounting doesn’t work due to a single debtor. In short, if your business has only one or two large clients, invoice discounting might not be the best financing solution for you.
Choosing the wrong financing company – Businesses that do understand the invoice discounting process can have a bad experience if they don’t choose the right invoice discounting company. An ideal invoice discounting company would offer professional services without causing any disruption to the seller’s business. A good discounting company would release funds at the right time and with minimal hassle. Hence, it’s very crucial that you choose a trustworthy financing company.
While you should consider the above factors before opting for invoice discounting, there are a few other ways you can mitigate the risks:
Robust legal framework: There should be a legal agreement signed by the supplier and the financing company for ensuring that the interests of all the parties are well-protected.
Verification process: A supplier should verify its customer invoices before they become available for the financing company to purchase.