Incisive Financial Understanding

INVOICE FACTORING / INVOICE DISCOUNTING

If you are short of cash and profit is weak, invoice factoring or invoice discounting might sound perfect. Often it is. Sometime it's not.

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 finance pitfalls:

• Invoice factoring or invoice discounting arrangements, when activated, typically see any prior bank overdraft facility withdrawn entirely (especially so where the invoice finance facility is through a different lender).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 frighteningly 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 cutomer 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. You also need to watch for the financial cap on the facility. And although, on the face of it, this might look bad these facilities do, in practice, serve to improve the cash flow of an awful lot of businesses.

• Don’t leave the decision as to whether an invoice finance facility will be good for you to the lender / intermediary; they typically don't have your best interests at heart. These people are effectively just salesmen (focused on commissions and targets). Many people sign up on the back of a 1 hour meeting with their Bank Relationship Manager. 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, thus making his cash flow worse and, of course, charging him for the privilege. This, combined with other aspects of the factoring facility, have taken him to the point 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 don't 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 it's sold) that this 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 and 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).

• Invoice factoring or invoice discounting does not necessarily remedy cash flow pressures. The explicit linking of sales invoices to cash flow suggests that if you have these facilities you should seek to ramp up your sales effort. And it looks to be a complete no-brainer -the obvious solution to easing cash pressures. Yet, if a business is already living hand-to-mouth, higher sales usually makes things worse. and these facilities will not prove your salvation. As lenders sense things getting worse they will cut the % advance 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 this as a funding option.

• 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 above 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.

• Be clear how much the facility is actually costing you. A recent case illustrated how this can be obscured. A client was unusually receiving a 100% advance against 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. Unravelled, the client could have funded his business on credit cards for less.

• 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)?

• 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.

• Invoice finance - personal experience: Two of the most distressed businesses we have worked with were already using invoice financing when we got involved. To come back to the 'heavy-duty steroid' analogy, the provision of the facility lulled them into an entirely false sense of security. 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.

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.