5 Effective Strategies to Improve Your Business’s Cash Flow
Today, cash flow is considered the fundamental prerequisite for the survival and growth of any business. Invoice discounting is one effective means towards smooth cash flow, as through invoice discounting, companies can unlock the value of unpaid invoices. While offering vast benefits such as immediate access to funds, it also carries some risks, which are essentially credit-related. Thus, in this article, we shall discuss how businesses can mitigate these risks and ensure robust financial security with the help of treds (Trade Receivables Discounting System) and through appropriate risk management policies.
What is Invoice Discounting?
Invoice discounting is a type of finance in which the firm sells its unpaid invoices to a financial institution at a discount to raise cash immediately. Unlike in factoring, the company retains all control over its sales ledger and collects client payments. This form of finance would give businesses more cash flow without waiting for the entire payment cycle.
One advantage of invoice discounting is that no traditional loans are required, and no collateral is needed. However, the business must be aware of all the risks potentially coming with its case, particularly the credit risk resulting from customers’ non-payment.
Credit Risk in Invoice Discounting:
In invoice discounting, the company receives funds immediately; however, if the customer defaults, the business may remain liable for repayment to the financial institution that also provided the advance.
Credit risk is the likelihood that a debtor might fail to meet their financial obligations, resulting in a loss for the lender. For example, a customer may delay payment of an invoice or, in the worst-case scenario, fail to pay it altogether.
For instance, this risk becomes even more essential if the customer is relatively new or questionable. Because invoice discounting typically operates on a non-recourse basis, the company is fully risked when a customer defaults. This can become disastrous for SMEs because one defaulted invoice can cause financial stress.
Credit Risk Mitigation through TReDS:
This will reduce credit risk through TReDS (Trade Receivables Discounting System) – an online platform that offers trade receivables discounting, particularly for the MSME sector. The Reserve Bank of India manages TReDS and provides a safe and transparent platform for MSME access funds by discounting invoices from large corporates.
Through TReDS, the businesses will benefit in the following ways:
It ensures a regulated and transparent environment where buyers and sellers are verified entities, substantially minimizing the risk of fraud or engaging with unreliable customers.
Reduced Risk Payment Defaults: Because TReDS connects businesses with large, credit-worthy corporations, the risk of default payments is much lower than doing business with an unknown or unreliable customer.
Non-Recourse Funding: Non-recourse funding is the primary benefit of TReDS. The financial institution bears the obligation of the buyer in case the latter fails to pay. Eliminating the economic loss for a business unit in case of default.
Better Credit Terms: TReDS may help MSMEs secure better credit terms that enable timely payment without exposure of accounts to default risk.
Access to a Wider Network: TReDS opens avenues for access to a broader network of financiers and corporates in an MSME, thereby increasing their choices for invoice discounting for instant funds in hand.
Risk Mitigation Strategies for Invoice Discounting
Apart from using TReDS, companies can use a mix of the following strategies as they go ahead to invite invoice discounting and minimize credit risks involved:
- Evaluate Customer’s Creditworthiness:
Before any form of invoice discounting, the task would involve an assessment.customers’ creditworthiness. Detailed checks on credit regarding a customer’s payment history, stability, and credit score can enlighten the precise expectations regarding an expeditious outcome. This serves trade through the credit bureaus and financial data available.
- Diversify Customer Base:
High-concentration risks arise through dependence on a single or very few customers.Defaults in any of the customers may cause disruptions in cash flow. The business should look for diversified customers to spread credit risk across various clients so that defaults from one client do not significantly affect the industry.
- Follow well-defined payment terms:
Clearly outlined payment terms, including deadlines, late fees, and interest rates for overdue invoices, in return, help minimize credit risk.
The communicator conveys the information. Such articulated payment provisions prevent most disputes and delays and ensure that businesses protect their cash flow.
- Use Credit Insurance:
Credit insurance is very useful for businesses involved in discounting invoices. By insuring its receivables, a company would save itself from incurring a loss because its customer failed to pay off. Thus, on default by the client, the amount due by the customer is covered by an insurance policy, and therefore, cash flow does not get disrupted.
- Analyze the Trends of Payment:
Determining the payment trends by clients will enable businesses to act on the possible problems before becoming defaults. Look at the warning signs, which include late payments, requests for an extension, or a sudden change in the customer’s behaviour. You would be able to tackle possible credit risks that might occur much later at such an early point.
- Negotiate Better Discount Rates:
Alternatively, in some cases, a business may negotiate for higher discount rates with financial institutions if given more security and guarantees. That way, the company will reduce its economic burden and still be allowed to benefit from access to funds through invoice discounting.
Conclusion:
Invoice discounting is one of the essential financial tools for those businesses that are interested in reducing cash flow without accepting traditional loans. Of course, there are risks involved in this tool, mainly credit risk. For example, using platforms like TReDS and proper risk mitigation strategies such as customer creditworthiness assessment, customer diversification, and credit insurance will mitigate financial mishaps for business operations. Altogether, an effective invoice discounting strategy shall provide liquidity to ensure sustained growth while keeping at bay the possible exposure to credit risk.
