Invoice Discounting as Opposed to Small Business Bank Loans
A huge majority of business entrepreneurs would still opt for business loans from banks in order to meet their long and short term financial obligations. Bank loans are credit facilities offered by banks with a fixed amount for a stated period to be repaid on a regular basis. Businesses with well laid out plans and excellent credit ratings would often have access to instant bank loans.
On the other hand, invoice discounting is a form of asset based lending whereby capital is created out of a business’ outstanding invoices. Invoice discounting is a suitable facility for businesses that are comfortable with chasing their own invoices and managing credit control. Both bank loans and invoice discounting are arguably favourable sources of business finance and could be beneficial to a business in need of funds, considering their existing financial resources. However, both forms of finance differ in unique ways.
Source of funds
Bank loans are lump sums offered to businesses whereby all the funds come from the bank. Simply put, a business is borrowing money from a bank to be repaid in monthly instalments plus interest charges. On the other hand, invoice discounting is a facility whereby a business has access to cash advances against outstanding invoices. In principle, the funds are outstanding to the business but are paid before the due date of the invoice.
Length of facility processing
Bank loans could require extra timing in terms of processing the loan application. A lot more paperwork is involved and in most cases, businesses would need to present a well laid-out business plan and try to persuade the bank that their idea is a profitable one. Also, banks would have to consult credit rating agencies such as Experian to score a business before lending to it. With an invoice discounting facility, once an invoice is raised, up to 90% of the invoice value could be made available within 24-48 hours. To qualify for an invoice discounting facility, lenders would be most interested in the quality of your customer(s) which in most cases would be other businesses. Simply put, invoice discounting has fewer conditional requirements and the funds are made available quicker when compared to bank loans.
Generally, banks are very conservative with their funds and tend to offer loans to established businesses with a proven trade history. They tend to target the credible ‘large’ businesses. Start-ups and emerging companies would always face a hard time trying to secure a bank loan. Invoice discounting targets large businesses with at least a 3 year trade history. This is simply because the lenders need to be sure that the business can chase its own debt and manage credit control without any third party assistance. Moreover, banks and independent lenders offering invoice discounting have an alternative facility which is specifically suited for SMEs and start-ups – this is called factoring.
Term of contract
There are two types of bank loans; short-term loans and long-term loans. The average short-term loan runs for a period of under 3 years while the average long-term loan runs a period of 10 years. Within these stipulated periods, the business repays the loan in monthly instalments from the business’ cash flow. An invoice discounting facility runs up till the time when the business’ customer settles their invoice. Outstanding payments often last 30-120 days which make invoice discounting a much shorter and effective form of finance when compared to bank loans.
Because banks lend the monies deposited by its investors, they often require some extra security from businesses when they seek loans. These loans are usually secured against the business’ assets (e.g. equipment and machinery) or against the personal assets of the business’ owner. The same scenario applies to limited companies applying for bank loans. With invoice discounting, the business borrows a percentage of the value of the outstanding invoice from a finance broker, effectively using the unpaid sales invoices as security for the borrowing.
Third Party Involvement
Bank loans generally involve two parties – the business seeking the loan and the bank. With an invoice discounting facility, there are three parties involved; the business seeking the facility, its customers and the factor company. The factor company is directly involved with the business’ customers so as to assess their credibility whereas a bank loan is a financial agreement between the bank and the business
The cost of a bank loan is the interest rate charged on the principal value borrowed. These rates vary between banks and give businesses the opportunity to shop around for the most suitable rates. The average bank loan interest rate is 9.9% APR and it’s charged throughout the duration of the loan. Loans will appear cheap in the short run if a business meets the financial criteria set by banks. On the other hand, risky businesses might be charged higher rates because of the increased chance of defaulting.
Invoice discounting has two associated costs; the service fee and discounting fee. The service fee is the charge that the lender levies for administering the facility. It is often charged as a percentage on the annual turnover of the business seeking the facility and is charged as a flat fee on a monthly basis. The discounting fee is the cost of borrowing money and is charged as a percentage over a base rate – the interest rate.
Comparatively, invoice discounting offers a more cost-effective facility and provides funding for your business just when you need it. It is a facility suitable for businesses that do not have access to bank borrowing or have been turned down by banks. However, businesses need to take into consideration its financial resources before applying for either form of finance.
This business advice article by Sema Fongod from Touch Financial, provider of invoice discouting services.