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Working Capital Loans vs Invoice Factoring

By Annapoorna

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Updated on: Mar 27th, 2023

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10 min read

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Various financing options are available to business owners seeking funds to cover their day-to-day cash needs. However, with so many financing options available, choosing the best one can seem like a challenge. In this article, we discuss two of the most popular short-term financing options: working capital loans versus invoice factoring. 

Meaning of Working Capital Loans 

Businesses generally operate on credit and therefore require cash to run their operations on a day-to-day basis. In simple words, the money needed by a business to run its daily operations, like paying creditors, daily business expenses, and staff salary, is known as working capital. 

For example, your business operates on a credit of 90 days. However, you have to pay your creditors within 60 days. This creates a scarcity of cash in the business to meet daily needs. You also must pay for other expenses like staff salary, administration costs, electricity and transportation. 

Sometimes, businesses fall short on cash and cannot meet their short-term needs. At such a time, businesses seek a working capital loan. It is a short-term loan that helps them meet their working capital needs.

Unlike term loans that are taken to finance a business’s long-term requirements, a working capital loan is made available to help the business meet its current needs. Cash credit and overdrafts are some examples of working capital loans. Generally the cash credit limit is calculated as a percentage of the stock and debtors. For example, a bank may allow a cash credit of 50% of (stock+debtors). 

Meaning of Invoice Factoring 

Invoice factoring is a type of working capital finance that allows business owners to meet their short-term cash needs with the help of their accounts receivable.

The company sells their accounts receivable to a third party that immediately pays the bulk of the invoice amount. The third party or the factoring company now collects the payment from the creditors. As soon as it receives the total payment, it deducts its fees and pays the balance amount to the business. This way, the company is able to meet its short-term cash needs. 

For instance, you operate on a credit policy of 90 days but have to pay your creditors in 60 days. The bulk of your cash requirements depends on your receivables. Since you will receive money only after 90 days, you might face a cash paucity. 

To solve this problem, you can factor your invoices which involves selling the accounts receivable to a factoring company. This company will pay 80-90% of the invoice amount immediately. Now your customers will pay directly to the factoring company. After receiving the complete payment, the factoring company will deduct its fees and pay you the remaining invoice amount. 

Invoice Factoring Example

The example given below explains how invoice factoring works. 

Invoice Value

10,00,000

Factoring Fee (Ex: 2%)

20,000

Initial Cash Advance (Ex: 90%)

9,00,000

Remaining Advance

80,000

Total Received

9,80,000

 

Differences Between Working Capital Loan vs Invoice Factoring 

Although the terms working capital loans and invoice factoring are used interchangeably, they vary in various aspects. The below table presents working capital vs invoice factoring. 

Working Capital Loan

Invoice Factoring

Involves taking a loan against some collateral like debtors, stock, FD, etc. 

Invoice factoring does not require any collateral

Does not require selling any asset.

It requires the company to sell its accounts receivables. 

No involvement of the factoring company

Company sells the invoices to a factoring company. 

The business owner has to pay interest on the loan amount. 

The factoring company deducts its fees from the remaining invoice value.

The company can avail of the full amount depending on the collateral. 

The company gets only a partial prepayment of the invoice value (i.e. 80%-90%)

 

Which is the Best Financing Option for Businesses

Every business has different needs, and therefore, the one-size-fits-all formula doesn’t work. Here are the factors that you should consider before choosing the best financing option i.e., Working Capital vs Invoice Factoring, for your business needs. 

  • Purpose of Finance - The first thing to keep in mind while choosing the best financing option for your business is to determine the purpose of seeking finance. For example, you might need funds to carry out your daily operations, pay your creditors, expand your business, buy new machinery, etc. 
  • Cost of Financing - The next most important thing to consider before choosing a financing option is to study the repayment terms and factor in the costs associated with that method. For example, if you are planning to take a working capital loan, study the interest rates carefully. Similarly, if you are seeking invoice factoring, you need to explore the factor’s fees for different credit periods. 
  • Amount of Finance Required - You must also determine the amount of money that you need to meet your goals. 
  • Availability of Collateral - Some loans require collateral while some do not. You need to determine whether you have assets to hypothecate. In the case of invoice factoring, you need to determine if you have the required amount of receivables. 

Conclusion

Now that you are aware of Working Capital vs Invoice Factoring and also the factors to consider before choosing the right option, you can go ahead and select the best financing option for your business needs. 

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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