In our previous blog, we discussed methods to overcome working capital issues. In this edition of the series, we will be touching on the ways to identify the right price at which a company should unlock the liquidity from blue-chip companies.
Let us dive deep into the topic and outline the steps associated with it. Before rejecting a sanction due to discount rate while looking for liquidity against unpaid invoices, one needs to understand certain key points:
Time = Value of Money
What Is the Time Value of Money?
Money is worth more in the present than in the future because there’s an opportunity cost waiting for it. In addition to your loss of use, if you don’t get your hands on it right away, there’s also inflation gradually eroding its value and purchasing power.
How is it relevant for an aggressively growing working capital intensive Company?
- When one signs a business deal (to supply goods or service) with a customer of yours, most of the times one’s payment gets pushed to a futuristic tenure (varying between 30 to 120) days
- Most of the business is built in the credit cost for such credit period which is dominated by the buyer or seller
- For an aggressively growing company, cash in hand for every sale done gives scope to grow faster and also helps to negotiate better for future deals
Time Value for Money against Cash Discount (CD)
- The cost of getting the money faster against a sale is again dominated by the buyer and offered in the form of CD as we spoke in an earlier chapter
- It’s never a fair deal when you opt for a business deal with a customer and take CD from the same customer who knows the margin
- What if there is an alternate avenue where a seller can get money against the debtor outstanding at terms which are acceptable (well within the margins), which is quicker and completely trusting the receivable and nothing other than that
- The probability of churning that money is 3 times in a 90 days credit period with a customer, leading to an increase in top-line and at the same time overall margin too
Time Value for Money against a loan from Financial Institutions
- Time taken from identifying a need for working capital as a booster to increase the business/Topline and to actually getting the liquidity is too long making the entire activity time-consuming and not justifying the real essence of time value for money
- The timing of cash in hand is very crucial for a booster in the top-line.
Even though invoice discounting might have a higher discount rate coming completely unsecured and off-balance sheet (of course lesser than the business margin but higher than the available secured limit from financial institutions), the money gets credited in as early as 48 hours in most cases. This amount could be used to procure raw materials and other products/services at cash (better bargaining power when bought in cash) thus creating the availability of working capital for the business. It is essential to identify the need and time to get access to working capital, which will help to clinch many larger business deals from the market taking the companies’ top-line and bottom line to the next level.
Cost of Additional Securities & Collaterals:
Hope you would have gone through my second chapter which had an illustration on how the current financial institutions evaluate a secured working capital limit. Wanted to share some more insights on it:
- Balance Sheet based funding approach either restricts access to working capital to most of the companies or caps the working capital limit which is always baked by additional collateral (mortgage of property) apart from hypothecating stock and book debts and creation of charge in Report of Compliance (ROC)
- It’s always a dream for a growing company to get access to working capital from financial institutions but most of the companies curtail their growth or wind-up their business due to lack of working capital. According to C2FO Working Capital Outlook Survey, over 700 companies in India ranging in size from one to 10 employees to 100-500 employees. Only 12 percent of over 700 small and midsize businesses indicated that they had no difficulty in securing financing. Thirty-two percent of the companies surveyed had an increase in the need for liquidity greater than 20 percent over the previous year. 29% – receive late payments from their customers and 24% – have customers who extended payment terms in past-year
- Want of Additional collaterals makes the exposure secured from Financials institutions point of view but at the same time it increases the cost of borrowing to the customer indirectly (cost of legal documentation, stamping charges, hassles of mortgage and removal of mortgage, etc apart from manpower cost to run around for the same) which always gets unnoticed
- Blocking the collateral of the company or promoter for a working capital need and locking it, at a time when you actually have a CAPEX need wherein one could have used the collaterals better is a catch- 22 situation
Invoice discounting eliminates the need for collateral, as a business’ credibility is evaluated mainly on the basis of cash flows generated from blue-chip companies apart from credit score, company finance history before releasing the terms & conditions for the amount required.
“Cash flows from blue-chip companies decide the limit which comes completely unsecured minus the collaterals. Hence, no additional security cost has to be incurred by the business.”
Off-Balance sheet accessibility to liquidity
To explain what is Off-balance sheet, let me first explain what is balance sheet exposure and what it does when availed in excess
- All loans and advances taken from external sources falls under Balance sheet exposure
- If taken in access it brings down the credit rating of the company leading to an increase in the rate of interest or curtailing further drawdown of such loans and advances
- It also presents the strength/weakness of the company to the external world
What is an Off-balance sheet?
Off-balance sheet refers to items that are effectively assets or liabilities of a company but do not appear on the company’s balance sheet or if you convert a balance sheet exposure to a P&L entry.
How can Invoice discounting become an off-balance sheet
Futuristic Receivables (Debtors outstanding after raising the invoice) is a part of current asset and when one sells the right on that receivable to a person (can be an individual or entity) interested to buy at a discount becomes sale of the current asset, funds received from such sale of right on the said receivable becomes a P&L entry which not only gives liquidity to the company but it also eliminates the exposure to be moved to balance sheet.
Cash flows against such sales give liquidity to the company and the discount cost for such sale becomes an expenditure for the company.
Derecognise Receivable in its Entirety
Below is an extract from an article as per the IFRS standard of accounting entry which gives more clarity on how an invoice discounting becomes an off-balance sheet.
“On derecognition of a financial asset in its entirety, the receivable against the Debtor is replaced with the receivable against the Factor. Any difference between the carrying amount and the sum of the price (consideration) received (discount cost) shall be recognised in profit or loss.”
Benefits of Off-balance sheet access to liquidity
- Now, we can agree that Invoice discounting if taken from the right place makes it off-balance sheet
- Liquidity coming from such invoice discounting not only meets the working capital needs of a growing company but also makes the entire activity off-balance-sheet
- The Balance sheet from investors and stakeholders point of view is ‘healthy’
Financial Institutions follow a rigorous process and series of documentation to approve the working capital need. This can take days and become a tedious affair over time. However, with invoice discounting, one gets the advantage of keeping the method simple, smooth, fast, and online, ultimately enabling an efficient and transparent process.
What is the ideal price to get access to liquidity by unlocking the unpaid invoice?
- Credit Strength of the company who is raising the invoice
- Strength & Size of the company on whom the invoice is being raised
- Cash flow from the invoices raised to determine the limit and not the balance sheet
- Keeping the accessibility to liquidity completely unsecured, collateral-free, and off-balance sheet
- Last but not the least getting the liquidity in 48 to 72 hours
- All this is happening on the platform using end to end technology
Determine the price for accessing the liquidity if one is looking at unlocking the unpaid invoices.
You can read more about how KredX is helping businesses to get quick working capital with the help of maintaining customer relationship in our next blog ‘Understanding KredX’s client relationship’