Invoice Finance - Good or Bad

I was asked to write an article for accountancy web last September as invoice financing was becoming more popular amongst bank managers looking towards a change in type of facilities offered. Last month I attended a Corporate Finance Conference where I talked to an invoice finance provider.

This type of facility still seems to be very popular and I thought it would be worth posting the article on here...

Invoice Finance - Good or Bad

Despite the talk of ‘green shoots’ many business owners are still having difficult conversations with their bank managers as they try to renew facilities. A significant problem is that many businesses have become reliant on using generous overdraft facilities to fund working capital. More often than not when it is time to renew these facilities, bank managers and their credit teams are keen to reduce facility levels because of shifting risk models, which leaves business owners with projected cashflow deficits and sleepless nights. The offer of an alternative funding solution from the bank, such as invoice finance, can seem like the answer to all their prayers, but is it the right route?

Checklist

Before entering into an invoice financing agreement, business owners should first consider the following:

1. Why do you need additional funds and what is the most appropriate form of finance?
2. Carefully review terms and conditions, lock-in periods, service charges and interest rates
3. What will be the impact on your accounts team? Can they cope with the additional workload?
4. Review your systems and procedures as these will be audited by the bank

What’s involved?

Invoice financing enables lenders to secure debts under a fixed charge, unlike most overdraft or loan situations, where security over trade debtors would only be classed as a floating charge. With more risk-averse banking structures being implemented over the last 18 months, it’s obvious why this route has become more popular with banks, as it provides a specific and measurable level of asset cover.

Factoring involves a company selling its invoices to a third party, which will then allow the company to draw loans against the money owed on the invoices, while it processes the invoices and collects the debts on the company’s behalf. Invoice discounting is similar, but the company keeps control over its sales ledger and the debtors still pay the company direct, while the third party provides loans secured on the total invoices outstanding. Invoice discounting can be a confidential or a disclosed facility, usually depending upon the risk profile of the company and the quality of its customers.

There is no doubt that invoice financing can provide business owners with a solution offering a flexible funding option that can provide increasing facilities as the business grows. When the customer settles the invoice the cash is repaid, interest (or a discount) is charged on the balance of cash drawn down and a service fee is usually charged for providing the facility. With the exception of the service fees, this makes an invoice finance facility similar to an overdraft, except that the borrowing limit is set by turnover and the value of invoices outstanding.

This form of financing has grown exponentially over the past 20 years, and the emergence of many independent lenders, provides companies with a wider range of lenders to approach. Figures from the industry body show that between June 1998 and June 2008, the number of clients using invoice financing rose by over 110% to almost 48,500 companies, and during the same period, the amount of lending increased by over 300% to over £17m (source FDA/ABFA ).

Downsides

For a business with healthy sales and profit margins, the invoice finance facility will reduce as cash builds, as eventually sufficient cash will be built up to fund working capital. Interestingly though, it is this linking of facility levels to trading performance that may be the major downside for many businesses.

However, business owners are currently talking of sales being 10%, 20% and 30% down on 2008. Lower levels of turnover will inevitably lead to fewer debtors and less invoice value to finance. Whilst this will also lead to lower purchases, overheads will still need to be paid. If a firm’s turnover is reducing, there may be additional reliance on lending facilities, until action is taken to bring fixed costs such as overheads into line with the lower activity levels. ABFA figures to March 2009 show that the numbers of clients and lending levels have decreased over the previous nine months by 3% and 15% respectively.

Another issue that business owners might want to consider is the credit worthiness of their customers in relation to the value of the goods supplied to them. A supplier of goods that cost £15,000 each might find it cannot use its factoring facility to its full extent as the credit limit assigned to that customer by the bank may be less than £15,000. This is a particular issue where the goods sold are of a capital nature with a high unit cost.

Many invoice finance schemes offer insurance against bad debts which can be an added benefit of using a facility, but the premium also becomes an extra cost. The purchase of a trade indemnity policy can be optional, but sometimes it is a mandatory condition of the offer from the lender.

Preparing for the upturn

There may be a silver lining, however. As we bottom out of the recession many businesses will start to experience growth. This growth will lead to additional working capital requirements. An invoice finance facility is an ideal scheme to fund a business out of a recession as it provides cash quickly as the business grows therefore funding future growth and working capital.