- What is Invoice Factoring (IF) & Invoice Discounting (ID)?
- How does it work?
- How much does it cost?
- What happens if the business can’t pay back on time, due to a client’s bad debt?
- What is the difference between Invoice Factoring & Discounting?
- Why use this type of financing?
- Who is the best lender; how to choose a lender?
- How NOT to choose a lender?
- What are the alternatives?
- Case-Study – examples of company financing arrangements…
- The practice of using debtor-based finance
What is Invoice Factoring (IF) & Invoice Discounting (ID)?
Put simply, it’s a source of cash-flow for businesses / companies (when needed).
Invoice factoring and invoice discounting are forms of financing, which allow companies to raise money against their outstanding client debts as a form of cash-flowing the funding gap – most companies find themselves in need of financial assistance, at one time or another!
Invoice Factoring is taking on a company’s client invoice debt, on-going. Invoice Discounting is a form of Short-Term borrowing, against non-claimed sales invoices – both are a form of ‘Cash-Flowing’ a company’s growth.
Financing is commonplace amongst companies within both the service & manufacturing sectors. As companies expand, they take on more client business and this leads to more clients extending the credit terms (30 days) originally agreed upon – which puts pressure on the companies cash-flow funds; as salaries, suppliers, office space, VAT returns etc needs to paid for. This funding gap needs to be filled somehow, either by a cash investment into the business; by way as a share capital, director loan, by eating into profits within the business or by borrowing – this is where Invoice Factoring comes into assist.
For examples of how Invoice Factoring can work well for companies, please refer to the ‘Case-Studies’ pages at the end of this section…
How does IF & ID work?
Worth noting, not all client debts can be used to raise finance and the levels of funding available from lenders, varies greatly. In reality, the lender does not physically purchase your client debt but takes a fixed charge as security for the advance. Completion of an invoice factoring or discounting arrangement usually involves paying off any overdraft a company may have first, before funding is made available against a company’s debtor book.
Factorable debt – as with most commercial lending, the key factor which determines how much a company can borrow is the value of their asset/s – in the case of IF, it’s client debts as security. Not all debt / client debt can be factored or discounted, as a lender can’t rely on it as security – this includes;
- Items sold on a sale or return basis, as the goods can be returned so the lender won’t advance against this – for a debt to be factorable there must be a clean sale.
- Any debt on a ‘pay when paid’ basis i.e. holding a consignment of stock – unless an invoice has been raised & a payment date agreed upon.
- No ‘Contra’ deal can be factored – any such debts will be excluded from the funding arrangement.
How much does it cost?
The typical costs applied to debtor based finance, includes two main elements:
A service charge – in the case of factoring, this typically starts from 0.5% to 1% of turnover, up-to 3%.
Invoice Factoring is traditionally more expensive than discounting, as the IF service charge also includes the cost of providing a credit control service (and if applicable – bad debt protection).
Comparing the cost of debtor based finance, to the cost of a bank overdraft facility; be sure to add in any ‘management’ and ‘on-going set-up’ charges your bank imposes, together with the cost of credit control and insurance. Banks are regulated to disclose more of their finance charges across all their financial service products, after the advent of PPI cases!
What happens if your business gets into difficulty paying back?
As with financial lenders; IF & ID is no different – steps will be taken if a company is getting into difficulty – best to spot potential problems early!
Easiest way to track a company’s strength to pay the arrangement back, is to take over the company client debt & deal directly with the debtors – IF is therefore seen by lenders as a safer service to offer than invoice discounting. If a company’s account is looking precarious, the lender will suggest moving the account from ID to IF.
It’s key to keep future sales forecasts high, if sales future sales drop off – it’ll be harder for a company to pay back the services.
By rigorously policing each company account, this will reduce the risks faced by companies in not being able to payback as per the terms set. If this doesn’t work, then a complete halt on a company’s spending is put in-place – this could harm any future growth plans.
How do Invoice Factoring (IF) and Invoice Discounting (ID) differ?
For both IF & ID, the lender will provide funding known as an ‘advance’ against the value of the cash due in from client debtors.
As a company sets-up new payment terms with their clients, to recoup the overdue debt – the amount owed back to the lender will fluctuate on a day-to-day basis, due to the business advance altering. The amount of cash a company asks for the lender to send (or ‘draw down’) from is referenced against the security value of the client debtors; IF and ID have a number of differences in how they operate – the most important are:
Visibility & control – in addition to advancing the money, the lender also takes over management of the sales ledger and credit control and provides the active service of chasing customers’ payments on behalf of their company client. An advantage if credit control up-to now hasn’t been handled well – a notice is placed on all future invoices the debt has been assigned to the lender. Company’s customers will be aware of the notice, as they will also be contacted directly; making this a more public & recognised style of financing.
Why use this type of finance?
Debtor based finance has its advantages over the traditional overdraft funding arrangements with high-street banks: these factors make debtor based funding suitable for growing companies, where access to flexible funding helps grow a business & eliminate the risk of over-trading.
If the key focus for a company is having funds available for growth, by combining debtor based funding with other ‘non bank’ sources of finance such as specialist commercial mortgages, this can allow a company to raise significantly more finance than traditional high-street banking.
Company’s reputation / stability – as debtor based funding is seen to some as a last resort or indication of stress within a business; debtor based funding allows a maximum amount of cash available, rather than going down a high-street bank route.
Debtor based finance does however have a number of perceived disadvantages:
Funding stability – the loan amount will not alter even if a company’s client debtors drop-off. While the amount of loan isn’t affected in the short-term, banks usually base their level of loan on 50% of debtors book, but if a bank starts to see a reduction in monthly sales – it’s common for them to claw back the loan earlier than agreed so strangling any growth plans etc.
Costs – often seen as an expensive form of finance, but compared to all the costs involved with other forms of arranging available funding; bank overdraft finance, share partner options (on-going), debtor based funding is lower.
How to choose a lender?
This guide is intended to give you an understanding of the things to consider when deciding upon going down either the Invoice Factoring (IF) or Invoice Discounting (ID) route; firstly you need to decide upon this style of debtor based financing & whether it’s IF or ID. If yes, how to find the correct lender for your specific business requirements;
Worth noting – the factoring market has been expanding and lenders fall into 3 different categories –
1. Clearing banks’ owning branded firms – as expected, these firms obtain much of their work by their in-house bank referrals.
2. Large independents, most are owned by smaller or foreign owned banks or other financial institutions – providing both IF & ID facilities and asset based elements including; property, plant & machinery loans, stock and debtor finance – generically known as asset based lenders (ABLs).
3. Smaller independents – who mainly focus on factoring but may well have particular niches in; construction, government debt or care homes which can require particular expertise in lending.
Most of the clearing banks have reduced their risk in lending and costs of managing customers accounts, this means many businesses’ have found themselves moved on to IF or ID. There is quite a degree of ‘churn’ in the market as businesses seek a better deal elsewhere. This usually involves moving to an independent, by not having a tied stream of enquiries tend to try harder and offering better advance rates – more flexibility.
How NOT to choose a lender
For a company to choose the area of factoring for the first time, it’s going to be a hard decision as to which lender to go with; the cheapest quote isn’t usually the best lender!
The cheapest quote in the long run isn’t profitable, due to hidden charges such as TT costs. Some lenders quote low rates on the basis that they will make-up the extra on charges. Others give an ‘all in’ price, which tends to be higher but in the long run gives fewer changes to the overall cost – make sure you compare like-with-like when looking for quotes and what is included!
Many companies post their requirements across the marketplace, in the hope of getting the best deal but some lenders won’t spend time preparing a quote so go in low to win the business but add on the extra charges later on – the ‘all in’ lenders sometimes don’t quote as they know this happens so get excluded.
Any quotes generated at the initial quote stage will be solely based on the information given to the lender or their website, this may change quite considerably when the lender has visited and audited the company.
It’s best to obtain numerous accurate quotes and then (with expert advice) compile a short-list of three lender to assess their services.
What are the alternatives?
Block discounting –
Where debtor based finance is only available to companies where a good or service has been supplied and not used against any future contract business. If a company has a long-term agreed history of income i.e. rental, then it’s possible to borrow against future income – this is known as ‘Block Discounting’. This is more a one-off arrangement so usually goes through a specialist broker to investigate.
Stock finance –
Where stock is the main asset i.e. machinery, it’s possible to borrow against the high-value stock. As the stock security involved is ever-changing, banks have often been reluctant to provide lending.
Summary – Key Points
Invoice Factoring & Invoice Discounting have become mainstream parts of business finance, due to banks shying away from overdraft funding.
The high levels of advance obtained from borrowing in this way can enable a company to available funding for growth (particularly when combined with other non-bank sources).
Debtor based finance – the level of factoring cash available will be tied to a company’s trading performance, but not all debt will be fundable.
Invoice Factoring & Invoice Discounting differ; factoring provides collection services as well as funding, invoice discounting can be on a confidential basis.
More and more lenders have come into the market, giving freedom of choice but the choice between different funders can be complex as:
– Stock is difficult to value, but it can form part of an invoice discounting or factoring facility.
– There are related services which maybe appropriate for a businesses’ circumstances i.e. block discounting of future streams of income; or trade finance which can be used to fund the individual transactions such as goods for sale.
Using a reputable commercial finance broker, with good up-to date knowledge of the marketplace can help in sourcing the best products and lenders for your business!
A company needed access to more cash to fund production but their bank was unwilling to increase the agreed overdraft limit to the level required so the directors’ referred to their accountant.
They were introduced to an Invoice Factoring & Invoice Discounting company, because the factoring broker had recently made contact with their accountant it was explained to the directors ‘all factoring companies are more or less the same’.
The lender’s salesman visited the company and explained how his firm would advance up to 85% of outstanding debtors – once the overdraft, which was set by the bank at approximately 50% of last year’s level of debtors was paid off. This all made financial sense, as there would be cash available to fund growth – directors signed up for an invoice discounting arrangement.
The company failed a month later & this is why; the lender advanced 85% against the debtors, but only against ‘qualifying’ debtors – the lender’s terms included a ‘concentration limit’ which dis-allowed debt from any customers of over 25% of the total value of the ledger so it’s important to clear up all the terms loan terms. When the company came to do reconciliation at the end of the first month with the funding company they found almost 50% of its debtor book had been dis-allowed – the real effective advance was only about 42.5% (85% of the remaining 50%) of the value of its debtor book and not the 85% as thought!
Why didn’t the lender spot this problem first – maybe they did but the lender wasn’t going to lose from a company’s collapse. Not only would they able to collect their advance in from the debts, but also able to charge and receive their contractual ‘collect out fee’ of a further sizable percentage of the ledger.
This case study covers the reasons for the growing importance of IF & ID as a source of Introduction – best to do your research first, then take experienced impartial advice.
Funding for small and medium sized businesses at a time when banks are increasingly reluctant to provide overdraft funding, is increasingly being used to support business growth because:
– more flexible than traditional bank funding such as overdrafts; and
– allowing greater levels of borrowing to be raised against company assets available for security.
The case-study illustrates the dangers of choosing the incorrect funding package, or not understanding the terms in-place – therefore the need for right advice as to which lender’s terms are best for your company. The failure of the company could have been avoided by simply introducing the company to IF & ID’s with different policies, which range from small specialist independents to large subsidiaries of the main clearing banks. The company’s accountant was incorrect to think, all lenders are the same, specializing in lending against other assets such as stock, plant machinery and property – to make the right choice of lender it’s best to appreciate;
– what IF & ID are, how they work and when they might (or not) suit your business
– clearly understand the risks, costs and terms
– negotiate the deal which suits your business
Worth noting; businesses which expand faster than the level they can access cash (known as ‘overtrading’), even if trading profitably – simply run out of cash to pay suppliers. The funding available through debtor based finance is based on sales and debts, an ideal way for high growth.
The practice of using debtor-based finance
Once a company decides upon debtor based finance and have chosen a funder, it’s best to adapt business practices to obtain the maximum advantage the funding.
The ‘audit’ process – an audit of the debtor book, which may be undertaken by the lender’s in-house staff or sub-contracted out to a firm of accountants. Some firms charge for the audit to take place, to see how serious the company is – the charge can be refunded if the company goes ahead to use the lender’s services.
The audit information will normally want to see:
Aged debtors list – to show up any past problems or set-offs. Matching supplier balances against customer balances of the aged creditor list.
Cash-flow forecasts – funding requirements moving forwards.
Current/recent financial statements – to show the business’s current net worth & profitability (inc damage clauses / warranties etc)
Summary of invoices – raised per month
Credit notes – issued and bad debt experience over the last 12 months (inc CCJs and insolvency proceedings).
Bad debt history – if any, at what levels and what for.
Customer history – a key factor in assessing credit worthiness
Terms of client trade – assessing the terms of client business and paper trail.