On this page we can see the whys and wherefores of invoice finance risks, we are also going to take a look at the risks and benefits associated with invoice finance. If you have missed any of our previous pages please see the links at the bottom of this page, otherwise, let’s crack on!
“A ship is always safe at the shore but it is not what they were designed for”. Albert Einstein
It is a truism that those who never take risks in business are unlikely to achieve anything. Leaders must accept that taking risks is simply part of business, and as Richard Branson once said: “Screw it; just do it! Failure is often just an indication that you have made a wrong turn. Keep trying, and eventually, you will succeed with your business“.
Fail fast – and learn even faster.
Managing risk and reward can be a tricky business in itself. Statistically, you are at your most vulnerable as a start-up or young business. Inevitably, the key difference is that more experienced entrepreneurs are not afraid to seek – and pay for – professional help. When a company is younger it often does not have the cash to pay for advice so more vulnerable.
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A quick introduction to invoice financing
Invoice finance is the umbrella term for factoring and invoice discounting. Both financing methods are built on similar foundations.
Factoring is a funding agreement in which you sell your invoices (payments due) to a third party. In return, you receive an advance of between 70-90 percent of the invoices’ value. When your customers pay, you get the rest of the payment, less the factor’s fees.
In a factoring agreement, the factor manages the credit control and collections processes on your behalf. This mitigates the risk to them. Because of this, your customer(s) will be aware that you are using factoring as a short-term funding source.
Invoice discounting is a very similar agreement. You sell a single invoice or your entire debtor book for an advance payment. However, in an invoice discounting agreement, you continue to manage your own credit control and collections process. Your customers need not know there is an invoice discounting agreement in place.
As there are two different types of invoice financing, it makes sense to tackle them separately. What are the potential benefits and risks of each?
Why has invoice finance become so popular?
Invoice financing has soared in popularity over the past couple of years.
Let’s look at the numbers:
- There are between 5,000 – 7,000 new sales a year.
- The value of the invoices sold to invoice financing providers has risen 368 percent since the year 2000.
- There are 38 percent more lenders.
- Invoice Discounting has grown from £15bn in 2009 to £25.4bn in 2014
- Factoring has grown from £16bn in 2009 to £19.8bn in 2014
What’s the reason for this surge in popularity?
Primarily it’s because there is a limit to the risk involved.
This is because:
- Borrowing is based on cash that is already owed to the business.
- Borrowing grows and falls in line with the company’s sales.
- Businesses have a solid exit plan in the form of their accounts receivable.
- In factoring agreements, lenders are responsible for their own repayments.
- Banks are lending less to small to medium sized businesses.
- Younger directors are more switched on to the benefits of the alternative finance market.
- Technology (like ours) is providing greater access for businesses.
Factoring provides numerous benefits. But, as with any type of funding, there are also some potential risks. Let’s explore the pros and cons so you determine if factoring is the most suitable source of finance for your business.
The benefits of factoring
- A boost to cash flow: Factoring can provide a quick and substantial boost to cash flow. If you are short of working capital, this can be extremely beneficial. For example, if you have outstanding invoices of £100,000, you could access £70,000-£90,000 within just a couple of days.
- Competitive pricing: There are now more factoring firms than ever before so prices are generally quite competitive. As always, make sure you shop around – and do not simply go with your bank’s factoring provider. The surge in popularity means you have many options to explore when it comes to lenders.
- Time savings: The factor manages the credit control and collections process. This leaves you with more time to focus on growing your business.
- Improved financial planning: Factoring helps to improve budgeting and cash flow planning.
- Negotiate better deals: Factors have dedicated credit control teams, which many small businesses do not have. This means they may be able to give you useful information about the credit standing of some of your customers or help you negotiate better terms with suppliers.
- Bad debt protection: If you choose non-recourse factoring, you will be protected from bad debts.
- Better customer quality: Factors perform enhanced credit checks. This can help your business trade with higher-quality customers and improve your debtor spread (that is, your debt is spread amongst more customers instead of concentrated in just a few).
- No security required: Unlike traditional bank loans, you do not have to use your home or other commercial assets as security. The loan is secured against the value of your debtor book.
- Access more funding: The 70-90 percent advance on your debtor book may be more than you would be able to borrow from the bank.
- Less control: Once you sign up for a factoring agreement, you lose a measure of control of your business. For example, the factor might not allow you to do business with a particular customer because of their poor credit history. Alternatively, you could just keep that customer’s account out of the factoring agreement.
- The stigma: Factoring is sometimes associated with businesses that are struggling to manage their cash flow. Customers are aware of your factoring agreement; they are notified when the factor takes over and they pay the lender directly. This could impact your reputation.
- The cost: Factors manage the credit control and collections process: this pushes the costs higher. Find out more about the costs of factoring.
- Reduced profit margins: As with any type of finance, this is not free money. Your profit margins will take a hit as a result.
- Limited borrowing options: When you enter into a factoring agreement, your debtor book is no longer available as security. This limits other potential sources of borrowing, such as a bank overdraft.
- Funding fluctuations: Factors disallow payments from those they deem to be ‘poor quality’ debtors. This may result in fluctuations in the lending amount.
- Exiting arrangements: If you want to end your factoring arrangement, you must repay the money that has been advanced but not yet paid by your customer. This may require some planning so it doesn’t result in a significant cash flow shortage.
- Customer relations: Relationships with customers are often strengthened when you work with them directly. The presence of a factor could harm relations with customers who would prefer to pay you.
Is invoice discounting the better option for your business? It has many of the same benefits and risks as factoring. There are also some unique pros and cons. Here are some of the ways your business could benefit from an invoice discounting arrangement.
The benefits of invoice discounting
Retain control: In an invoice discounting agreement, your company continues to manage the credit control and collections process. You maintain the same credit control operations you already perform.
Confidentiality: Because you retain control of all your business operations, there is no way for the customer to know that an invoice discounting agreement is in place.
Lower costs: Invoice discounting does not include the additional costs of credit control and collection, making it cheaper than factoring.
‘Bolt-ons’ are available: Invoice discounting is more flexible than factoring. You can tailor a deal to meet your needs. Bad debt protection, payroll support and other services are available to free up your time and reduce your risk.
Reduced interest costs: You only pay interest on the funds you borrow, which can make it more flexible than factoring.
The risks of invoice discounting
- Limited availability: This method of financing is often extended only to businesses with an established, proven credit control and collection process. Why? The risks to the provider are much greater than in factoring because the invoice discounter has no control over the debtor book. They need to be sure they are making a ‘safe bet.’
- Commercial invoices only: Invoice discounting lenders, like most factoring providers, only offer advances on business-to-business transactions. You cannot borrow against business-to-consumer sales.
- Hidden costs: Some lenders bury hidden costs in your agreement. It is essential you know exactly what you’re paying for.
- Cost: Yes, invoice discounting is less expensive than factoring – but form of lending can sometimes cost more than an overdraft or loan.
- Dependency: Some businesses can become overly dependent on invoice discounting. This can make it difficult to leave an agreement without impacting cash flow and sales levels