Alternatives

What to do when you need to use factoring or invoice discounting The alternatives to factoring or invoice discounting including trade finance, construction application funding and block discounting.

For a variety of reasons already discussed, factoring and invoice discounting will not be appropriate, or even available, for all businesses or situations. However there are some related services which may be relevant to your business so for completeness these are outlined below.

Self funding solutionsSelf funding solutions

There are mechanisms that may allow you to self fund your business, for more information CLICK HERE.

Block discounting

As forms of debtor based finance, both factoring and invoice discounting are only available where goods or a service have been supplied and can therefore be invoiced. Therefore they cannot be used to raise funds against future contractual income as despite being certain in terms of timing and value, this has yet to become a debt that is actually due and payable.

Where you have a long-term stream of contractual income such as a rental income from property or machinery, then you may however be able to borrow what is in effect an advance against this future income through what is known as block discounting. This is a specialist market where each deal is very much a one-off tailored to the particular nature of the asset and contracts involved so you are likely to need to use an independent finance broker to investigate such funds.

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Machinery dealer finance

In some businesses the main asset is stock rather than debtors which gives rise to a problem as lenders are generally reluctant to provide facilities secured against this type of asset. There are some limited exceptions to this, one being for experienced dealers in machinery who can demonstrate a successful track record in spotting and converting opportunities at a good margin.

This type of business generally requires a revolving facility secured against the equipment currently in stock which allows the stock to be sold on and funds to be reused to purchase further items for resale. Since the security involved is an ever-changing level of stock this is an area where banks have often been reluctant to provide appropriate facilities.

As a result independent finance companies can now provide facilities of up to £2.5m in the first instance to fund the buying in of assets to sell on. These can provide flexible funding that can be drawn down as required of up to 100% of the cost of the asset together with duty and VAT. This obviously provides the appropriate solution, but as a specialised product providing funding for areas where the banks are reluctant to do so because of the security risk, the cost of such borrowings tends to be high.

Trade finance

This type of funding then brings us on to trade finance which should be seen as the financing of a particular transaction or series of transactions, rather than as a loan to the business. Trade finance houses act to provide cash to finance a transaction that you have set up and a typical example might involve funding the importation of a container of goods from overseas for resale here.

The funding available ranges from:

  • the funder purchasing the goods themselves, arranging and financing transport and customs clearance, only reselling the goods to you immediately before you sell them on to your customer; through to
  • the funder guaranteeing payment to the supplier but not actually having to remit funds.

The funder’s principal requirement when lending in such situations is the ability to clearly see the route through to the recovery of its funds. They will typically therefore look to:

  • fund finished goods (although some will occasionally finance the purchasing of components for assembly prior to sale);
  • support transactions with a high gross profit margin;
  • see that a significant majority of the goods (sufficient to repay the borrowing) have been pre-sold;
  • on terms that do not include any element of sale return;
  • to creditworthy customers.

Critically for a trade finance house the success of the specific transaction being funded is what really provides them with their security. Therefore to be able to lend they have to be completely confident that they will be able to recover their money from a successful sale of the goods which can affect their ability to fund. On the other hand, since they are looking at specifics of the transaction and are simply concerned with whether it may or may not be successful they will also be very flexible about the type of transaction to look at and they will not necessarily be concerned:

  • if your business is in financial difficulties;
  • if the goods are being purchased from the UK or overseas;
  • if the goods are being sold to the UK or overseas; or
  • if the goods ever actually land in the UK.

Case study

A trade finance house was happy to fund the purchase of a large quantity of electronic consumer goods for delivery in the autumn, even though the importer had not presold the consignment. This was because the finance company took the view that it could rely on the goods selling in the run up to Christmas.

Advances and rates will be tailored to the specifics of the deal involved and type of financial support required. Some lenders may also insist on factoring your debtors as part of such an arrangement so that they can be paid out immediately on sale of the goods.

In addition to these arrangements some of the trade finance companies discussed below will offer finance by way of supplier undertakings. Crudely this can in effect mean that they use their ability to obtain credit to purchase goods that you need from your suppliers on your behalf, and then sell these on to you at a margin as part of a financing arrangement.

This type of facility can be very useful where for example, a business has a large and profitable contract to undertake but it lacks the working capital to finance the required purchases, or where a business is in temporary cashflow difficulty and is therefore unable to obtain credit itself from its suppliers for the goods it needs. Each such arrangement will need to be tailored to the company’s particular circumstances and as a tailored solution will be costed accordingly.

Construction contract funding

In addition to the limited number of factors who will fund construction type debts or applications, some trade finance houses have also set up arrangements so as to be able to fund construction contracts.

These arrangements typically require the funder to be written into the contractual arrangements between the client or main contractor and the company undertaking the work. For this reason they can therefore only be set up at the start of the contract.

Letters of credit and loans against imports

Where buying from an overseas supplier you may be asked to provide a letter of credit (or ‘LC’). This is essentially a promise by your bank or trade finance house to pay the supplier for the goods upon production of the relevant paperwork, which is normally the documentation showing that the goods have been shipped. There are two main advantages of this to your supplier:

•                firstly, they do not have to rely on you for payment but can trust your bank; and

•                secondly, they can present the letter of credit to their own bankers as an irrevocable promise to pay for the goods once delivered and use this as security on which to borrow from their own bank in order to manufacture the goods for sale, a process known as discounting an LC.

Where your bank (or other funder) issues a letter of credit this has the same effect as if they had promised to issue a cheque on your behalf. A bank will therefore take this liability (sometimes referred to as ‘blocked funds’) into account when considering how much overdraft facility to allow you.

So if you would normally have sufficient security to support a £1m overdraft but you have issued letters of credit for £250,000 through your bank, the bank will normally only allow you an overdraft facility of £750,000 so as to maintain their total exposure to your business at under £1m, even although they may not have to pay out on the LCs for some months.

Once the supplier has provided the relevant paperwork and been paid out on the LC this cost will then be deducted from your bank account. Banks will sometimes offer a loan against imports (‘LAI’) facility for say 120 days which means that from the date of payment of the LC it will be 120 days before the cost plus the LAI interest is deducted from your bank account. This is designed to enable you to sell the goods and recover the cash from your customers in order to be able to meet the payment of the LC.

Obviously, where you are using trade finance your suppliers may wish to be paid using LCs from your trade finance house. If this is the case you need to be very careful as to how much you will be charged.

Case study

The company imported goods from the Far East and provided its suppliers with an LC payable on shipping of the goods (generally on three months terms) which the suppliers then discounted with their own bankers to fund the production of the goods. The company then paid off the LC within 45 days by selling the goods on once they had arrived in the UK and cleared customs. To fund a new line of business requiring £2m of LCs it sought quotations from two trade finance houses for which the charges were:

Funder A Funder B
Flat charge for funding the transaction 3% Nil
Monthly LC interest rate 1.75% 2%
Calculation of interest charge Daily from date that the LC is paid out From moment LC raised, calculated monthly for each month or part month

Most of the other terms and administrative charges to cover the costs of issuing the required documentation were similar.

The difference in the interest costs the business would face from the two lenders differed markedly however:

Funder A Funder B
Total interest cost Flat fee of 3% +
2.6% (45 days at 1.75% pm) =
5.6% or £112,000
3 months since LC raised plus
2 months to cover the 45 day shipment and sale period gives
5 months at 2% per month =
10% or £200,000

Lender A also came up with a number of suggestions as to how the company could structure the transaction to avoid having to pay any interest such as by issuing the supplier with a longer term LC. This would mean that lender A would not have to pay out for 45 days after shipment, so eliminating the 2.6% interest charge resulting in a 3% charge in comparison to lender B’s 10%.

Information provided is copyright and subject to the Important Notice on the home page.

Of course the information contained in an article like this can never be a full statement of the legal position as the relevant laws are complex and liable to change. This article can only therefore be a general guide as to the issues involved and as these can have serious implications you should always seek appropriate professional advice on your own particular circumstances before taking any action.

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