Invoice Discounting or Overdraft: Pricing Receivables Finance

Invoice discounting turns an unpaid invoice into cash now, for a discount and a fee. An overdraft or cash credit lets you borrow against your overall business up to a limit and pay interest only on what you use. To compare them you have to put both on the same footing: the effective annual cost of the money you actually receive, over the time you actually have it.

Headline rates hide the difference. A discounting facility quoted at 12% can cost more than an overdraft at 11.5%, and it can still be the better choice.

How each works

Overdraft or cash credit. The bank sanctions a limit, usually against stock and receivables, often with collateral. You draw and repay freely. Interest is charged on the daily balance used. The limit is reviewed periodically, commonly each year.

Invoice discounting. A bank, NBFC or platform advances a percentage of a specific invoice, often 75 to 90%, and recovers the money when your customer pays. It charges a discount, which works like interest for the days the advance is outstanding, and usually a processing fee per invoice. For suppliers selling to large corporate or government buyers, regulated trade receivables discounting platforms also exist, where financiers bid on invoices the buyer has accepted.

The same ₹10 lakh invoice, both ways

A component supplier has invoiced a large customer ₹10,00,000 on 60-day terms and needs cash now.

Invoice discounting

• Advance: 80% of the invoice, ₹8,00,000.
• Discount: 12% a year on the advance for 60 days: 8,00,000 × 12% × 60 ÷ 365 = ₹15,781.
• Processing fee: 0.5% of the invoice value, ₹5,000.
• Total cost: ₹20,781.

Effective annual cost on the money received: 20,781 ÷ 8,00,000 × 365 ÷ 60 = about 15.8%.

The fee is what moves it. On a 60-day invoice, a 0.5% fee on the invoice adds nearly four percentage points a year to the cost of the advance, because it is charged once on a short period. On a 30-day invoice the same fee would add more than seven.

Overdraft

Drawing the same ₹8,00,000 for 60 days at 11.5%: 8,00,000 × 11.5% × 60 ÷ 365 = ₹15,123.

Effective annual cost: 11.5%, plus any annual processing or renewal charge on the limit, spread over the year’s usage.

Rates and fees are illustrative. Use the actual discount rate, fee structure, advance percentage and day-count convention from your own offer letters, and check whether GST applies to any fee.

Why the more expensive option can still be right

Availability. An overdraft needs a sanctioned limit, and banks size it on your balance sheet, your collateral and your track record. A growing business often outgrows its limit before the next review. Invoice discounting grows with sales, because each new invoice is new security.

Collateral. Discounting is secured on the invoice and, in effect, on the customer’s ability to pay. A supplier selling to a strong buyer can borrow on that buyer’s credit quality rather than its own.

No unused-limit cost. Some limits carry charges whether or not you draw. Discounting costs nothing in a month you do not use it.

Keeping the overdraft free. Funding a large order’s receivable through discounting leaves the overdraft available for everything else.

What to read in the fine print

• Recourse. With recourse, if the customer does not pay, you repay the financier. Without recourse, the financier bears that risk, at a higher price. Most small-business facilities are with recourse, which means the credit risk has not left your business.
• What happens if the customer pays late. The discount keeps running beyond the expected date, sometimes at a penal rate.
• Disclosure to the customer. Some arrangements require your customer to pay the financier directly, which tells them you are financing receivables.
• Minimum volumes or exclusivity. A facility that requires all invoices from a customer to go through it is not a flexible tool.

A simple decision rule

1. Compute the effective annual cost of each option on the cash actually received, including all fees.
2. If the overdraft has room and costs less, use it for routine cycles.
3. Use discounting for large or unusually long invoices that would exhaust the overdraft, or when the limit is full.
4. Compare either with the cheapest alternative of all: getting paid sooner. A 2% discount for a customer paying on day 10 instead of day 60 costs about 15% a year, similar to discounting, and involves no lender.

Where this fits

• Why receivables need funding at all: cash conversion cycle · how much working capital a business needs
• When the customer does not pay: what to do when a customer is not paying
• Converting quoted rates: rate converter · flat to reducing rate converter
• How lenders judge capacity: DSCR