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INVOICE FACTORING AND INVOICE DISCOUNTING

Invoice finance is a generic term and applies to both invoice factoring (where the lender collects money due and controls the sales ledger) and the more popular invoice discounting (where control over collections is retained by the business). Albeit there are many hybrid offerings.

Invoice Factoring & Discounting - The practical realities:

• Invoice factoring or invoice discounting arrangements, when activated, typically see any prior bank overdraft facility withdrawn entirely (especially so where the invoice finance facility is through a different lender).
• Invoice finance generally (and invoice factoring in particular) is a multiple of the cost of an overdraft. But if your biggest issue is ‘access to finance' (and it often is) invoice finance (in some form) may still be the right choice. That said, many entrepreneurs we encounter in our financial training work see invoice finance akin to a drug habit - something they would desperately love to be able to do without. Not exactly the most positive endorsement.
• At a fundamental level the majority of people, it seems, simply don't understand how these arrangments work. We know this because if the factor (or discounter) proposes advancing (say) 85% of the gross invoice value, almost everyone we encounter assumes they get the other 15% (less a bit for charges) once the customer pays. And there is, of course, an undeniable logic to this. But it's not true. You cannot and will not understand how one of these facilities works by looking at a single invoice. The lender advances you up to a maximum of (in this case) 85% of the value of your entire sales (or receivables) ledger at any point in time (assuming all sales invoices are eligible). So you don't get the other 15% until you close the facility. It's that simple. And although you might not feel quite as keen as you did before, don't kid yourself.  No lender is sitting on a pile of cash that is rightfully yours. The lender has advanced you money against a pile of your customer invoices - intrinsically worthless paper.  And in most cases these facilities will serve to make more cash available to a business than is possible through an oversraft.
• Terminating a factoring agreement (if things don't work out) and taking back control over the sales ledger in-house sounds straightforward enough but in practice isn't. Typically those who have experienced the endless hassle once, never want to go through it again.
• Factors make money on the funds they lend to you through the interest charged. Curiously, where is the incentive for them to collect money from your customers quickly and thereby reduce what they are lending you (and the associated interest cost)?
• Even with a discounting facility where you are responsible for the debt collection, don't forget that an overdue receivable is something you are probably paying interest on by virtue of having had to draw down more money than you otherwise would on the facility.

Invoice Factoring & Discounting - What is the lender looking out for?

• Any invoice finance lender has one concern - that the sales you make give rise to 'collectable debt'. This means any and all of the following matter greatly (and can influence the level and need for personal guarantees):
  • signed proofs of delivery
  • strong Terms & Conditions
  • financially sound customers
  • a product they understand
• Lenders don't want and won't fund any invoices that pertain to stage payments or that are interim in nature. (But if this is part of your work they might still be happy to look at the rest).
• In terms of the construction sector specifically, lenders don't like 'applications' (essentially payment requests). There is no security for them in these; it's invoices that count.
• Some lenders (not all) like a large spread of customers. Where this is an issue to a lender they build 'concentration limits' into agreements that restrict their exposure if (say) a certain customer (or perhaps a certain sector) exceeds x% of your total sales ledger. You must be aware of this before you sign (and remember afterwards). Many is the time clients calculate what they can afford to pay to suppliers (from the funds they expect to be able to drawdown) only to find the availability of funds has been limited unexpectedly.
• I saw, some time ago, a client discover (far too late) a concentration limit that applied to the industry sector their entire customer-base operated in.  Once the lender realised this, it rendered the facility effectively unworkable. I had a suspicion that the company might have deliberately misled the person who audited the business on behalf of the lender before the facility was sanctioned. This would have been such a short-sighted thing to do. Because typically, businesses operate so as to avail themselves of the greater funding available through their invoice finance facility. If this funding is subsequently (and often suddenly) withdrawn, a big funding-gap typically emerges. Insolvency is often inevitable.
• Some discounters / factors are only interested in funding invoices to your (say) 'Top 5' customers. Take this up if you wish but think through the administrative realities of making this work in practice when, say, your accountant / book-keeper is ill or on holiday. Or the lender may decline one customer (e.g. for poor credit history).  But perhaps this is somewhat more manageable. On the other hand, you might have a customer who consistently pays in 7-10 days.  In which case why would you want to discount or factor their invoices?
• Some invoice finance lenders are poorly equipped to fund invoices to customers overseas (e,g, if they ever needed to pursue legal action to collect the debt. They might have no relationships within that country to effect it). But if a high % of your sales are exports then check this aspect carefully with prospective lenders.

Invoice Factoring & Discounting - Make an informed decision:

• Don't leave the decision as to whether an invoice finance facility will suit your business to the lender / intermediary. They vary, of course, but (focused on commissions and targets) there is no guarantee they will have your best interests at heart. Many people sign up on the back of a 1-hour meeting. That is terribly naive. A particularly sobering story related to me recently concerned a very small business where the owner was sold factoring to supplant his existing pro-forma invoicing arrangements, actually making his cash flow worse and, of course, charging him for the privilege. This, combined with required changes in customer Terms & Conditions, have taken him to the brink of personal bankruptcy. It's easier than you think to find yourself in the same boat.
• Invoice factoring or invoice discounting must be subject to a detailed cash flow prior to any facility being formally agreed. If you choose not to bother, you are taking extreme risks with your business. And if (hopefully) you do bother, you must exercise real care. Many projections are themselves flawed and particularly so when it comes to accurately reflecting the impact of invoice finance facilities on a business over time.
• Expanding on the point above, invoice finance facilities are often (in fact) inadequate. It's natural to assume (often by the way they are sold) that the new facility will give you access to more money - a bigger facility - than you had before.  But that's not guaranteed. Pay particular attention to the proposed facility cap as well as the % advance. Be wary if your cash flow suggests you needing to draw down a high % of the funds that would be available to you. Often an issue for construction-related businesses (and they are by no means alone).  Don't assume that lenders generally (particularly in the current climate) will be falling over themselves to riase this facility cap just for want of you asking (even if you can point to resilient top-line sales growth).
• Be clear how much the facility is actually costing you. A good way to do this is to give different lenders the same scenario: Choose a typical balance on your sales ledger; an average amount that would be advanced by them (e.g. based on a 70% advance or prepayment) and (say) a 12-month time period. You should then be able to get a clear picture on interest charges, admin fees and associated costs.
• A recent case illustrated how this can be obscured. A client was receiving a 100% advance against net invoice value with no fixed facility cap aside from a periodic review. So far, so good. But the fee & interest were wrapped up in a formula linked to the age of the debt. Clearly a discounting facility by its very nature makes more sense if your customers do not pay quickly. And some sectors are prone to slow payment - as in this case.  Unravelled, the client could have funded his business on credit cards for less.

Invoice Factoring & Discounting - Do it for the right reasons:

• The two classic indicators that suggest this sort of funding arrangment may be appropriate would be customers take many days to pay (and despite your efforts you can't do anything to influance this) and also that your business is growing.
• You will note there is no reference above to weak profitability (and for good reason). While invoice-based fuinding is likely to ease cash flow pressures that have arisen from strong sales grwoth and cash waiting to come through from customers, it will help (much) less if the primary cause of financial problems is trading losses (or marginal profitability).  Indeed, the explicit linking of sales invoices to cash flow can be positively dangerous. It suggests that to ease cash flow simply ramp up your sales effort. And it looks to be a complete no-brainer - the obvious solution. Yet, if a business is already living hand-to-mouth, higher sales usually makes things worse. And invoice finance, in whatever form, will not prove your salvation. As lenders sense things going wrong they will often cut the % advance (reducing their exposure) and compound your problems. Hence why properly worked cash flow projections are always vital.
• Factoring and discounting arrangements rarely save on administration costs in practice. Additional reconciliation work and other issues often add to the burden. So as a way of cutting overheads this, in isolation, is not a good enough reason to pursue the idea of factoring or diuscounting.
• Because invoice finance based lending offers greater fees and security to lenders, there is intense pressure to have businesses convert from conventional (and much cheaper) overdraft facil;ities. It is arguable sometimes as to whose interest is truly being served by pushing these products. We've questioned as to whether lenders always take the necessary steps to properly gauge the suitability of their proposals in their eagerness to sign clients up (before others do). Some directors might find the attention flattering. Don't be fooled - be rigorous and hard-headed in evaluating the merits of the proposals made.

Invoice Factoring & Discounting - Where can you get leverage?

• Personal Guarantees. are almost always sought to give the lender extra protection if things go awry. But if the proposition is a strong one can that not stand up on its own merits? Quite possibly. And there are different levels of personal guarantee - unlimited and limited personal guarnatees. Even simple warranties. It's worth seeking legal advise on this and looking at what different lenders will be happy with. After all it's often your personal assets on the line. But understanadably, all lenders will want you to commit to helping them collect money from customers in a collect-out situation.
• The % advance and the facility cap have already been mentioned but they are key and may well vary depending on how different lenders see things. Also look out for concentration limits and the extent to which all sales invoices are eligible for funding.
• Of course, charges and interest rates are slef-evidently important to compare (but not in isolation). Note that if you tick the right boxes, mainstream lenders can be less than half the cost of specialists. Even if you think your financial position is not that great, it's probably worth trying one of the big names even if you have to compromise on the personal guarantee.
• Another issue is the basis on which unpaid invoices are recoursed back to you (i.e. taking them out of the funding equation). After how many days does this happen? Until recently, a client found this was happening on 90 days (the average time his local authority clients took to pay). Clearly unworkable. Look for 120 days.
• If your business is viewed as marginal for invoice finance lending (particularly if it's small) lenders will want to offer factoring rather than invoice discounting. It gives them far greater control, including the ability to contact clients directly. And it can come at a substantially higher cost. Factoring is very much on the wane.

Invoice Factoring & Discounting - Words of warning

• Too often, as is typical with finance, people leave these things far too late. They give themselves no time to do even the essential cash flows or the opportunity to shop around. If a lender knows there is nobody competing with them, you will pay the price. Always get at least two involved.
• Finally, some personal experience.  Two of the most distressed businesses we have worked with were already using invoice financing when we got involved.  Perhaps like a 'heavy-duty steroid that serves to hide your symptoms rather than cure the problem, the provision of the facility lulled the people running these businesses into an entirely false sense of security.  They merely saw that the more they sold, the more cash they would get.  And sadly it had them fail to address the real issues at the right time. .

We help companies make the right decisions when it comes to raising finance - in terms of what is appropriate; what is achievable and the amount needed.  And we have some contacts in this field.

We can prepare robust cash flows (often remotely) from information supplied and remit them with full explanatiry notes in pdf format or printed by mail. Take a look at our Cash Flow Support for more details.