All you need to know about invoice financing
Everything you wanted to know about invoice finance but were afraid to ask...
What is invoice finance?
Invoice finance is a flexible loan, based on your debtor book. As you issue invoices to your clients, an invoice finance provider will advance money to you, based on the sum of those invoices. For a growing business it’s a helpful way to overcome any cash flow problems. Providers lend you a percentage of the unpaid invoice before its paid, and the balance when payment is received, less fees. There are two flavours of invoice finance. The first is factoring, where you hand over your debtor book and credit control to your invoice finance provider. The second is invoice discounting, where you raise money against the invoice but still retain control of the relationship with your client.
Who uses invoice finance?
A lot of businesses. It’s one of the most popular and accessible forms of finance for growing businesses: 15% of all independently owned businesses now ‘sell’ their invoices as their main source of finance. In total, over 30,000 smaller businesses use invoice finance as a funding option, a number that rose by 10% between 2001 and 2002. Growth in the sector comes from the fact that invoice finance is now the preferred business financing option pushed by banks and a growing number of independent firms who offer the same service.
As Mark O’Neil, regional sales director at Independent Growth Finance points out, it’s increasingly difficult for small businesses to raise traditional forms of bank finance “without personal assets to pledge such as bricks and mortar”. The beauty of invoice finance is your debtor book is the only security you need.
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How will invoice finance help my business grow?
Quite simply, invoice finance unlocks capital due to you as soon as you raise an invoice. So instead of waiting 90 days for company A to pay you, while supplier X is demanding payment after just two weeks, invoice finance will bridge the gap, allowing you to fund sales growth and business expansion.
Can my business use invoice finance?
To obtain invoice finance, your business must be raising invoices where the goods or services have been delivered prior to an invoice having been issued to the customer.
So which businesses aren’t eligible for invoice finance? Gerry Hoare, of Enterprise Finance Europe says: “Invoice finance suits business-to-business. If a company doesn’t operate on a ‘sell and forget’ basis – ie invoicing after providing a service or goods – you have to question whether the debtors will pay in an insolvency situation. If there’s an opportunity for dispute over whether the goods or service has been delivered, invoice finance may not work.”
According to research by the Factoring and Discounters Association, the UK industry body, over a third of all factoring clients are from the manufacturing sector, with services, transport companies and engineering also likely adopters.
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While the invoice finance industry used to say that companies should have a minimum annual turnover of £80,000 to justify the fees involved, providers are increasingly open minded. Angela Harvey, of Alex Lawrie Factors, says: “If a business has a good idea and the only thing stopping them is cash we will try to help. We look at a business and the opportunities it has, whereas traditional providers tend to demand security and a track record.”
As a general rule of thumb, if your business sells on credit, has a good spread of debtors and boasts growth potential, you are likely to benefit from invoice finance.
While Ann Horan, chairman of the Factors and Discounters Association (FDA) points out that “the discounter will minimise risk by seeking to fund only companies that exhibit strong and competent management and have a good spread of debtors,” some providers will fund a business that relies on just a few clients.
How much invoice finance can you raise?
There’s no rule of thumb as to how much money you can raise. It will depend on your needs, the industry you work in and the strength of your debtor book. Invoice finance providers will typically start by advancing an average of 75% of your invoices and then, based on the credit worthiness of your clients and the strength of your business, this can grow to 95% or even 100%.
You also don’t have to hand over all of your invoices. “If a client only needs to fund a certain amount we will set it at a certain percentage. We remain flexible so that we can increase or reduce that percentage over time,” says Harvey.
It’s important you check what a provider is prepared to offer you and how flexible it is before you commit. “A business might sell £10,000 worth of goods to a customer and expect to be advanced £9,000, but if the credit rating of that customer doesn’t match, the provider might only be prepared to advance 50%.” The type of invoice finance will also affect how much you can raise.
Factoring or invoice discounting?
There are two key forms of invoice finance: factoring and invoice discounting. Both work on the same principle, but factoring is a full service that allows you to effectively outsource your whole credit control function. Your factor will carry out credit checks on your customers and advance payment on your invoices, as well as managing your sales ledger and chasing late payment.
Factoring tends to suit smaller companies who don’t have a dedicated accounts department. “It takes all the hassle out of chasing payment, for a small percentage of the invoice value,” says Stuart Holloway, managing director of RBS Commercial Services. “We will tailor how we collect debt to the client’s needs, but the standard way is to send a statement one month after the invoice is issued, followed by a chasing letter, say seven days after the invoice was due, if it remains unpaid.”
Some factoring companies will only chase the invoices that hold the most risk, so it’s worth checking how many customers or invoices a factor will chase, as well as how it will be carried out, such as by phone, email or letter. You will need to make sure this fits with how your customers like to be treated.
Invoice discounting is a more basic service. You will retain responsibility for chasing late payment, while the provider will simply advance the money. This facility tends to suit larger companies who have an accounts department. “It’s not generally available for businesses with annual turnovers below £1m or those with a weak balance sheet,” says O’Neil. This is because the provider lacks the control that a factor has and therefore incurs more risk.
The downside of factoring – other than perceived ‘loss of control’ and cost – is often image. “When first used in the UK, invoice finance was associated with ‘last resort’ finance, mainly as a result of factors taking on too many unsound businesses. Since then businesses have worried that factoring may be seen as a sign of financial weakness,” says O’Neil. Now, increased flexibility and product awareness, use of technology and greater competition have changed most people’s perception. Companies that use factoring do lose the personal interaction with customers, which many value. Clients must be happy to deal with a third party, which doesn’t go down well with every business. Invoice discounting is viewed more favourably, but some may still think it’s being used because the company is not performing properly.
How much does invoice finance cost?
This is dependent on your turnover, which provider you use and whether you choose factoring or invoice discounting, but it’s standard to be charged two fees: service charge and interest payments. Service charge is a percentage of your turnover and interest is based on the amount borrowed.
Generally, the smaller the company the larger the percentage of turnover charged. While factoring service charges will vary from 0.3% to 3%, charges for invoice discounting are more likely to fall between 0.1% and 1% of your turnover. Interest rates are likely to be between 1% and 4% over base rate.
“Ask yourself just how much time you spend chasing payment,” says Holloway. “If your turnover is £50,000 and you are spending time chasing debts when you should be making money. While the debt remains unresolved for longer and longer, you can either employ a bookkeeper for £15,000 a year or you can pay £4,000 to a factoring company.”
What about bas debts?
You can protect yourself against non-payment by paying extra for a ‘without-recourse’ service, which insures your debts and means the provider will pick up the bill. Typically this will add no more than 0.4% extra to your annual service charge.
If you choose not to sign up to a ‘without-recourse’ service you will be expected to make good the bad debt to your provider costing you money and time.
“If your debtors are well spread and are low risk, you are less likely to need credit insurance, but even a portfolio of blue chip customers can cause problems. It’s always worth considering,” says Peter Ewan of Venture Finance. At worst your failure to collect debt could result in the collapse of your business, particularly if the debt that is bad is with one of your major customers.
How do you choose a provider?
Don’t always choose the provider that will lend you the most money. “It’s the worst thing you can ask, but it’s often the first question,” says Holloway. “You need to know how reliable the factor’s systems are and how they will deal with your customers.”
You will also be talking to your provider everyday so ensure you feel comfortable with them and that they understand your business. Make sure they aren’t looking after so many clients that you will be just a number, and ensure that you will have fast, easy contact with the right person.
Before you sign anything, check the contract thoroughly. “Some providers stipulate that you only get out of the contract on an anniversary date – not one day earlier or later,” says Harvey.
While a provider might dangle a 90% advance figure in front of you, you must make sure there are no hidden restrictions, such as concentration of clients or credit insurance obligations.