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Invoice discounting and factoring: When do they make a good business choice?

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When it comes to business resilience and keeping cash flowing, businesses now have a range of options – so what do accountants and CFOs need to be mindful of when opting for invoicing discounting or factoring?

3rd Nov 2021
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Mention invoice discounting or factoring to a director, and often the immediate response is “won’t that be expensive?” and “surely, everyone who uses an invoice discounter or factor goes bust.” 

The myth that invoice finance such as invoice discounting and factoring are forerunners to a company become insolvent is just that – a myth. 

It is a perception that the invoice finance industry has been trying to change for years and goes back to the pre-Enterprise Act 2002 days when having exhausted all options to raise finance.

Companies who had ignored all the warning signs that they were struggling would turn to invoice financing as a last attempt to make ends meet only to find that they still couldn’t generate the finance quick enough to save the business, simply because they had turned to an invoice finance facility far too late.

As with everything to do with business finance – timing is important.

Funding of the last resort?

As Philip King, former small business commissioner, and non-executive director at Optimum Finance, explains, “In the past invoice finance had a reputation for being the funding of last resort. When used effectively – especially for a growing business – both invoice discounting and factoring are great solutions helping businesses to thrive.

“They need to be considered as alternatives to the traditional and often more expensive forms of funding such as overdrafts, term loans, or credit cards.  They are also flexible and can grow in line with business needs.”

It’s a great way for smaller businesses to improve cashflow, it’s also a form of funding that’s used by high-growth businesses.

Gary Davis, UK head of sales, Bibby Financial Services added: “One of the many benefits of invoice finance is that it’s future-focused, so invoice financiers look at the future potential of a business, not just its trading history.

“Invoice finance is hugely flexible, and helps businesses unlock working capital for a range of scenarios, including cashflow funding, new equipment purchase, growth and expansion, international trade, management buy ins and buy outs, refinancing, corporate restructuring and mergers and acquisitions. So, while it’s a great way for smaller businesses to improve cashflow, it’s also a form of funding that’s used by high-growth businesses.”

How does invoice discounting and factoring work?

Invoice finance works by unlocking the cash that is trapped in unpaid invoices. 

Factoring is the purchase of trade receivables (invoices) from a company on an ongoing basis, where the financier provides funding against outstanding invoices, as well as full credit management and administration of the sales ledger.

Whereas invoice discounting is factoring without the provision of credit management and debt collection activity, which remain the responsibility of the company. 

Invoice discounting can be either (1) confidential (CID) where the clients’ debtors are unaware of the facility or (2) Disclosed (DID) where the involvement of the financier is known to the debtors.

Riskier option?

Confidential invoice discounting (CID) is perhaps the most attractive as the supplier’s customers are not aware of the facility but can present a greater risk to the discounter.

As a result, the selection criteria can be tight with three years of profitable trading required as standard amongst most discounters, and to minimise the possibility of fraud, discounters register a charge on book debts, often requiring directors to back this up with personal guarantees.

“Invoice financiers use various methods to protect themselves against the risk of fraud,” explained King. “In the event of a company using two factors or invoice discounters, then any ‘doubling’ could be prevented by apply a debenture against the receivables which would be apparent to the second financier.”

In both invoice discounting and factoring the invoice financier pays the company/supplier an agreed percentage of the invoice value on an agreed date, generally up to 85%. Thereafter, the financier collects the full amount from the customer. 

Companies know in advance that they will receive prompt payment of an agreed percentage of all their invoices – thus ensuring good cashflow for the business and the financier when paid in full by the customer earns a profit.

“Using a factoring or invoice discounting facility does not absent you as a business from adopting best practice credit management policies and procedures,” said Sue Chapple FCICM, chief executive, Chartered institute of Credit Management (CICM). 

“Indeed, it may be argued that such policies are even more important in monitoring your cashflow and mitigating risk.”

This is something for directors to bear in mind given that if an invoice financier is unable to collect on an invoice, they will recoup the money from the supplier company. If they are unable to do so, they will seek to minimise the risks of losing funds they have advanced to the company by calling on director guarantees. 

Therefore, with both invoice discounting and factoring the creditworthiness of the supplier or company’s own customers are a key factor. Likewise, the simpler the product or service the less chance that disputes will arise.

Essentially only three things will stop a customer paying: (a) lack of financial ability to pay; (b) being unable to pay due to waiting funds from its own customers, and (c) unwillingness to pay owing to outstanding disputes. 

When it comes to (b) I have known an invoice financier to work with the customer in helping them collect in their own debts in order to service the invoice financier’s own client’s invoice – often gaining a new client in the process.

The ability to establish a satisfactory audit trail is a key factor for invoice financiers, and they will be keen to establish that should the supplier company itself fail, then customers will not be able to enter any spurious disputes to avoid payment. 

As a result, prior to getting involved with a company, the invoice financier will audit the paperwork that evidences sale and establish that the customer having received the goods or services in accordance with the order, the debt would be enforceable in law, thus giving the invoice financier security in the debt.

Who uses invoice finance?

Invoice finance and factoring is available to businesses trading on credit terms with other businesses. In the UK there are around 40,000 businesses using invoice finance to improve cashflow, drive growth and expanding into new markets.  

Both invoice discounting and factoring represent a good investment for both SMEs and large organisations, especially when scaling up the business.

Invoice finance reduces the risk of overtrading by enabling businesses to scale

“There’s a common misconception invoice finance is only suited to small businesses or those in core sectors, but this really isn’t the case,” says Davis. 

“While invoice finance is well suited for those in manufacturing, construction, transport, wholesale and services sectors, at Bibby Financial Services, we support businesses across 300 industries, so it’s a form of funding that works for an array of businesses – and many of our customers have been with us for years.”

“Invoice finance reduces the risk of overtrading by enabling businesses to scale and therefore service their working capital needs alongside their sales growth,” added King. “It has the ability to scale in line with the business’s growth and needs, and invoice finance is arguably more effective than other forms of funding. It can also remove much of the administration burden associated with credit management and allocations.”

Adding to the toolkit of accountants

In these challenging times, accountants and CFOs need to have a range of tools at their disposal.

Tools such as invoice discounting and factoring unlock cash in a business and can make a major impact on valuation, cashflow, profitability, corporate growth, and offer a way for businesses to unlock cashflow they already have within their businesses and improve their credit control, avoiding the need to take on additional debt.

For accountants trying to help clients navigate today’s challenging times, helping them to emerge stronger, invoice finance is a tool that can improve working capital, deliver faster more accurate forecasts, and shape strategic decisions that delivers long-term resilience for businesses.

Replies (7)

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By Hugo Fair
03rd Nov 2021 16:49

Two words sum up why the sector has a (broadly deserved) poor reputation ... Greensill Capital.

If you are outsourcing credit management & cash collection then you are admitting that someone else (who doesn't know your business) can do these things better than you (with your hopefully in-depth understanding of the business processes, client buying cycles, etc).
That knowledge is integral to the performance of your business ... if it's missing then you have more substantial problems than just cashflow - and if it's not then tackling things in-house will be more cost-effective, as well as providing you with valuable daily feedback.

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By hyper10
04th Nov 2021 10:40

When I post, I clarify I'm not an Accountant but read this for interest. In this reply, I can say that Factors and Invoice Discounters are last resort of desperate people.
Most customers don't allow it in their terms and if they do it will have restrictions. The drawdown advertised or sold to you will be so complicated that it's too late to do anything about it.
They claim to advance 80% of an invoice but thats subject to their credit limit applied and spread over the debtor book. I once did a job for a FTSE100 company and on an £80k invoice, due to the various requirements was allocated under £20k.
It is truly a loaded dice,

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By roundwindow
04th Nov 2021 11:18

@ Hugo Fair: its precisely because many SMEs do not have the resources to undertake an effective credit control/ collection function that they might usefully outsource this to a specialist as part of a financing and ledger management package.
I agree Greensil is an egregious negative, but it's quite wrong to paint the long standing industry with the same brush
@hyper10: re ban on assignment, the Business Contract Terms (Assignment of Receivables) Regulations 2018, apart from a few isolated situations, disallows the situation you suggest. And as for the "last resort of desperate people", you could please explain how in 2021 in UK and EU there will be around two trillion Euros of Client turnover handled by the RF industry - yes, that's two with twelve zeros after it - c. 11% of the regions GDP.
There is a clear positive correlation between economic growth and the use of RF - it simply is not the reserve of the desperate.

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Replying to roundwindow:
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By Hugo Fair
04th Nov 2021 11:43

@John Brehcist: you are at least consistent, in that much of the content (and all of the tenor) of your response follows on seamlessly from your only other post of 10 years ago. And of course, everyone's entitled to their opinions.
I'm not sure how this promotion of outsourced financing fits with your ethos of 'helping CEOs and their companies define and develop their strategy, structure, process and people' ... but again, each to his (or her) own.

What however is undoubted is that what may work (and even be of benefit) to larger corporations doesn't tend to be helpful at the smaller end of the market - and can even be harmful.
In nearly 50 years I've only encountered factoring when a company of < £25m t/o is in (foreseeable) trouble - through cashflow and/or over-extended borrowings.
That doesn't mean there are never suitable situations, but does mean it raises a large red flag for many people (including suppliers & clients).

Oh, and your point about the scale of the industry in Europe? I'm tempted simply to say that size isn't everything! But in the world of finance it can even be, to make a very mixed metaphor, it's Achilles' heel (just try measuring the value of swaps immediately prior to the 2008 collapse).

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By CJaneH
05th Nov 2021 14:55

My observation in the past that they collected the good payers and not the slow/none payers so the business still has all the hassell for a small improvement on cash flow from the good customers.

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By Paul Crowley
07th Nov 2021 16:09

Never a good choice for my kind of client
Paying to get in the money from clients that will pay anyway
Then borrowing money under rules that are incomprehensible to a standard trader

Bad debts costing more than the bad debt?

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paddle steamer
By DJKL
09th Nov 2021 17:07

Years ago I had one client, metal fabrication re a refinery mainly, who used factors, but he/she was cute . Invoices got raised one month, next month credit notes issued plus new invoices then raised, they effectively treated their invoice factoring as a Ponzi scheme, that is until one day I drove out to them and the yard was locked and deserted.

Maybe it is an age/generation thing but all my experience was that doing the books, squaring the control accounts etc, was a right faff.

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