The truth is that the average high street bank’s lending policies are unlikely to change in the near future; but there are other options for SMEs looking to source funding – via their sales ledgers.
Invoice finance is growing in popularity as it offers a relatively simple solution to a variety of funding needs; there are two types – factoring and invoice discounting.
We’ve enlisted the help of Simply Business Finance Product Manager David Summers to explain the differences and the pros and cons of this type of finance.
What’s the difference between Factoring & Invoice Discounting?
Factoring is essentially selling on your invoices to a third party at a discounted rate. The third party will advance you a percentage (normally up to 90%) of the value of your invoices. As you’ve sold these invoices on, the factoring company will therefore be responsible for chasing payment from your customers.
Invoice discounting is a type of lending (again based on your sales ledger). As before, your chosen invoice discounting provider will advance you cash against your invoices; however, here instead of selling your invoices on, you are borrowing and using your invoices as collateral. As such you retain control of your debt collection and credit control.
As such, business owners who don’t like the idea of a third party company contacting their customers regarding payments (and potentially tainting their business relationships), may feel more comfortable with an invoice discounting solution than with factoring.
Why would a company sell its invoices on at a discount?
Unfortunately the reality is that many companies effectively act as a ‘bank’ for their customers. Let’s imagine you are a manufacturing business. You receive an order from a customer, and so buy in the raw materials needed to fulfil their order. Of course in addition to the raw materials you also incur costs for staff, heat, light etc. Your customer might then take up to 30 days from the invoice date to pay you. As such you’re acting a little like an interest free credit facility for them.
Imagine you receive another, larger order. Again, in order to fulfil this you’ll need to buy more raw materials, pay bills, staff wages etc. But you’re still awaiting payment from your first customer. You can’t afford to get the new raw materials in. The slow payment from your first customer could potentially mean that you’ll lose the business from your second.
This is a great example of when selling invoices on to a third party might be beneficial – as the business is better off getting paid a percentage of their invoice quickly as they can then plough these funds straight back into raw materials to enable them to fulfil the contract for their second customer; rather than having to await payment and potentially lose a contract.
How do Factoring & Invoice Discounting differ from Loans?
When a company requests a loan, the banks typically focus on the credit-worthiness of the business requesting the loan. However, when it comes to invoice finance (whether a company is looking for a factoring or invoice discounting solution) the factoring company will instead focus on the credit-worthiness of the debtors (i.e. the customers who have received goods and/or services).
As such for some businesses it can open up financing options which would otherwise not be available to them.
Will invoice financing work for every company?
There’s not a single solution (that I’m aware of at least) that will work for every company. One such consideration might be the level of profit margin that a company worked to. There are of course costs associated with invoice financing, and as such I’d hazard a guess that for industries working within very tight profit margins, the fees incurred through invoice financing may take too big a chunk of an already skinny profit, and therefore not be workable.
However – it is worth noting that there are costs associated with any type of financing, be it an overdraft facility, a loan, invoice factoring or anything else. As such, before entering into any sort of financial agreement I’d urge companies to ensure that they fully understand the agreement which they’re signing up for, and the costs involved. Take the time to do your homework and make sure you’ve found the right solution for your business.
What are the Pros & Cons of Factoring & Invoice Discounting?
There are pros with both approaches –
- When you issue an invoice you know when it will be paid making it easier to manage your cash flow
- You’ll have the capital to react more quickly to new opportunities
- Unlike an overdraft, this credit facility grows with your business
- May reduce the need for long term loans
When it comes to cons – it becomes a little more complex. It really depends on the needs of a given business. For example, if you elect to use a factoring solution, then the factoring company will take on the role of managing your sales ledger and chasing customers for payment. Now, for some customers this would be seen as a benefit.
However, for other business owners this might be seen as a drawback; as they may be concerned that a third party might upset their customers and taint the relationship which they’ve worked so hard to build. In this instance, invoice discounting might be a better solution – as here the company retains control of its sales ledger.
Is there a stigma attached to Factoring?
In some industries there may be a perception that those businesses that use factoring may be in financial distress; however I’d suggest that factoring (or indeed other third party financing solutions which include direct contact with clients) is pretty commonplace nowadays so this is something of an outmoded view. However, if of course this is a concern for a company, they may elect to use an invoice discounting solution instead.
In summary, whilst both Factoring and Invoice Discounting, might not be the ideal solution for every business, for some it can be a great way to manage cash flow and therefore have the funds ready to reinvest into the business without the need for taking on a business loan. Plus, as for some businesses the current lending policies of banks are unfavourable it can be a good way of accessing credit which might otherwise be unavailable to them.
I’ve said this once before, but it bears repeating – before undertaking any sort of financial agreement business owners must ensure that they fully understand the agreement, the costs involved and that it’s the right solution for them.