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Invoice Factoring vs. Bank Overdraft: Which is the best for SMBs?

By Annapoorna

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Updated on: Mar 27th, 2023

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13 min read

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All businesses need capital to grow- even more so—small and medium-sized businesses (SMBs). While SMBs generally have the option to opt for business loans, they are more suitable for longer tenures. To meet working capital requirements, SMBs usually opt for invoice factoring and bank overdraft, which provide flexible lines of credit. But what are invoice factoring and bank overdraft, and where do we stand on the invoice factoring vs bank overdraft debate? Let’s understand.

Meaning of Invoice Factoring with Example

An invoice factoring arrangement involves the business getting funds against its sales invoice, which it sells to a factoring company at a discounted price. Under this arrangement, the factoring company extends money between 75% to 90% of the invoice’s value to the business.

For instance, assume a business looking for short-term credit decides to sell a sales invoice worth Rs.10 lakhs to a factoring company. Thus, the factoring company advances Rs.9 lakhs (supposing 90%) against the sales invoice under the factoring arrangement. 

A factoring company charges a financing fee for such arrangements and withholds it from the funds advanced to the SMB. It also takes over the control of the debtor book and chases payments for the business.

Meaning of Bank Overdraft with Example

A bank overdraft is a facility extended by the bank to its client to withdraw money over what’s lying in their account. This facility is subject to a specified (maximum) limit and can be withdrawn by the bank at any time. 

Moreover, banks levy higher interest rates in case of an excessive withdrawal and can even refuse to honour their commitments.

To illustrate, consider a situation where the company’s bank account holds deposits worth Rs.10 lakh, but it needs to make payments amounting to Rs.11 lakh. So, if the company has a pre-arrangement with the bank to ‘overdraw’ its funds, it can pay Rs.11 lakh.

Thus, Rs.1 lakh has been withdrawn under the overdraft facility, and the company is liable to pay interest. Usually, the interest rates on overdraft facilities are higher than the interest charged on fixed-term loans.

Another example is when the government offered Rs.10,000 overdraft facility to citizens opening new bank accounts under the Prime Minister Jan Dhan Yojana scheme. Therefore, bank overdrafts serve as a safety net when tight cash flows. 

So, what are the differences between invoice factoring and bank overdraft? Read on to learn about invoice factoring vs bank overdraft.

Differences between Invoice Factoring Vs Bank Overdraft 

While invoice factoring and bank overdrafts extend short-term credit lines at flexible repayment terms, they differ considerably. The main points of difference between invoice factoring and bank overdraft are highlighted in the table below.

BasisInvoice FactoringBank Overdraft
MeaningIn invoice factoring, SMB gets a loan against the invoices it sells to a factoring company.In bank overdraft, an SMB can withdraw funds in excess of the amount lying in its accounts with the bank, subject to a specified limit.
Need for Pre-arrangementNo pre-arrangements are required for invoice factoring.An SMB needs to formally arrange an overdraft facility in advance to avoid paying any penalty.
CostThe costs under factoring arrangements are pretty standardised and easy to understand. However, they may sometimes exceed an overdraft facility’s costs.A bank overdraft costs more than a fixed-term loan as banks charge higher interest rates. The costs can escalate further in case of over withdrawals—at times even up to 29%. Banks are also free to raise their fees without negotiating with the SMB.
AccessInvoice factoring is easily available to all sorts of SMBs. However, some companies may only buy commercial invoices, thus making it difficult for B2C businesses to get funds under factoring arrangements.Bank overdrafts are hard to come by for start-ups and SMBs with poor credit histories.
TimelinessA factoring company usually provides funds within 24-48 hours of an application, which barely lasts 30 minutes.Applying for an overdraft process is time-consuming. Besides, getting an extension on the loan limits also involves a long procedure.
Loan AmountsUnder factoring, the business can avail of loans up to 90% of the total value of the sales invoice sold.The amounts under bank overdraft will be decided by the banks based on the size of the business, credit scores, and confidence in the SMB’s growth potential.
Loan Limits ExtensionWith the growth of the business, an SMB will have higher invoice amounts, and can consequently, apply for higher loan amounts.A loan limit extension is usually difficult under overdraft facilities and requires heavy negotiation.
CollateralThere is no requirement for an additional pledged security as the invoice serves as collateral.Banks may demand collateral or personal guarantees for sanctioning commercial overdrafts.
Terms FlexibilityFactoring terms are usually very flexible, as the SMB is in control of when to apply for funding and its frequency.SMBs are required to comply with stringent terms and can be asked to pay back on demand or be forced to shell out higher interest when limits are exceeded.
Reliability/ Facility WithdrawalInvoicing arrangements generally last over a few months or even years.A bank can easily withdraw the overdraft facility when it desires to.
Administrative CostsSMBs incur higher costs in managing invoice factoring arrangements as these agreements involve tough negotiations.Administrative costs incurred under an overdraft facility are significantly lower than under factoring.
Impact on Credit ScoreSince the enterprise sells its invoices, the funds arranged do not fall under current liabilities on the SMB’s balance sheet. Thus, the SMB’s credit score isn’t negatively impacted.Being a conventional credit line, an overdrawn bank account appears under current liabilities in the company’s balance sheet. This impacts the business’ credit rating and can restrict the business from availing of higher loans in the future. 

 

Which is the Best Financing Option for Businesses?

Now that we have cleared up the air on invoice factoring vs bank overdraft debate, how can you determine which financing option suits your business? We enumerate some factors for your consideration below.

Pre-arrangements

If an SMB has already negotiated for an overdraft facility, it is a no-brainer to utilise it. The only reason to switch over to invoice factoring will be to get a higher loan or if the business is becoming riskier, which has thrown your cash flows into disarray.

Accessibility

Like bank loans, arranging an overdraft facility requires meeting stringent norms and conditions. Banks may demand a thick credit profile, a strong financial position, and a solid repayment record. New businesses and start-ups may need help to meet this criterion and, thus, are better off choosing invoice factoring. Similarly, companies with low credit scores but reputable customers can opt for factoring arrangements.

Loan Amounts and Flexibility

Bank overdrafts are flexible only when the SMB adheres to the sanctioned maximum limit. Additionally, there are no fixed repayment schedules. Banks do retain the option of demanding repayment on demand. In contrast, invoice factoring is highly flexible, as business owners can get more money against their invoices as their business expands.

Reliability

If an SMB prizes reliability, it is better to go for invoice factoring, as the arrangement lasts as long as the terms are followed. This is unlike banks that may choose to withdraw an overdraft facility on concerns about the enterprise’s repayment ability.

Bottom Line

Funds are required at all stages of business, from purchasing plants and machinery to investing in new technology and processes to scaling their operations. 

Ultimately where you stand on the invoice factoring vs bank overdraft debate will depend on the conditions of your business. A bank overdraft is a great option if your enterprise generates static turnover, has a decent credit score, and can easily meet the bank’s eligibility criteria. 

However, invoice factoring is an ideal financing alternative if you are new to the business and are looking for a quick and easy way to raise financing, which scales as your business grows.

About the Author

I preach the words, “Learning never exhausts the mind.” An aspiring CA and a passionate content writer having 4+ years of hands-on experience in deciphering jargon in Indian GST, Income Tax, off late also into the much larger Indian finance ecosystem, I love curating content in various forms to the interest of tax professionals, and enterprises, both big and small. While not writing, you can catch me singing Shāstriya Sangeetha and tuning my violin ;). Read more

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