They can be a useful way of funding working capital and managing cash flow, especially for a rapidly growing business, but they also come at a cost.
Not surprisingly the finance comes at a cost which will depend on the services being provided, interest charged and risk of loss to the lender, some being less scrupulous than others.
The amount charged will cover interest on funds drawn and a service related fees. The service fees will change depending on the volume of invoices, value of invoices, concentration of invoices, percentage drawn down, maximum amount borrowed, the level of monitoring necessary and any credit insurance. They can also include set up, audit and introduction fees.
The funding agreement, often hidden in the small print, will include event fees such as termination fees, default fees, collection fees, notice penalties. Many also require the support of personal guarantees. On the face of it they can’t lose money, but you would be surprised at how many do.
What is the difference between invoice discounting and factoring?
With factoring, the service provider takes on managing the sales, ledger, credit control and chasing of invoice payments. With Invoice discounting the business remains responsible for its sales ledger and invoice chasing.
When considering whether to use either service businesses should weigh up the costs against the benefits of freeing time to manage the business (particularly in the case of factoring) and the enhanced control over cash flow, especially if it is intending to grow.
However, again, particularly with factoring, other borrowing avenues will be restricted because book debts will not be available as security. While this choice provides some protection against bad debts, factors will also restrict your borrowing against poor quality debtors by either disallowing them for borrowing purposes or recording them if they aren’t paid within terms.
In terms of customer service, a business will need to consider the effect on its customer relations of having no direct contact with the business, and especially, how the factoring service treats its customers.
With invoice discounting a significant consideration is how robust the business’ in-house credit and invoice processes are and how the service compares with the rates that may be charged on an overdraft or bank loan. It should be pointed out that banks no longer want to provide overdrafts as a way of funding book debts.
In both cases, the event fees can be sufficiently large to justify some lenders looking for reasons to trigger them. Even with scrupulous lenders, regular defaults become a problem for both parties.
While both services may be an option to consider for a healthy business, it is questionable whether they are helpful to a business that is already in financial difficulty. Turnaround advisers often find themselves having to negotiate on behalf of companies with factors and invoice discounters to persuade them not to pull the plug when, although the money loaned is covered the lender wants to end the relationship and recover their money.