How to choose

What to do when you need to use factoring or invoice discounting How to choose a factor or invoice discounter. This article is intended to give you a better idea of some of the things to consider when considering factoring or invoice discounting. Obviously you need to decide whether this type of debtor based finance is appropriate for your business in the first place, and if so whether you are better off with factoring or invoice discounting.

If you do want to go ahead, the next problem is in choosing the right lender for your business’s needs.

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The factoring and invoice discounting market

Before the credit crunch this was a rapidly expanding market with between 50 and 60 active factors and invoice discounters, however this has now fallen to about forty operating at the time of writing.

Even so, there are still however a wide variety of lenders falling into three main categories:

•                The main clearing banks’ owned and branded firms. These obtain much of their work by their in-house bank referrals although some work hard to produce strong solutions for clients and as a result are successful competitors in the market.

•                Large independents, many of which are owned by smaller or foreign owned banks or other financial institutions. These often provide both factoring and invoice discounting facilities as well as now being able to provide packages of structured finance combining any number of asset based elements including property, and plant and machinery loans as well as stock and debtor finance, and who are therefore sometimes known generically as asset based lenders or ‘ABLs’.

•                Smaller players, generally focused on factoring but who may well have developed particular niches such as construction debt, architects’ practices, government debt, or care homes which can require particular expertise in lending.

As the main clearing banks have sought to reduce both their risk in lending and their costs of managing customers accounts, many businesses have found themselves moved on to factoring or invoice discounting by their banks and as a result have transferred over to their bank’s in-house firm.

There is therefore quite a degree of ‘churn’ in the market as businesses realise that having lost their requirement for a banking relationship to maintain an overdraft, they are in fact free to seek a better deal elsewhere. This typically involves moving to an independent, which not having a tied stream of enquiries tend to try harder, typically offering better advance rates and more flexibility.

The number of players in the market is therefore an opportunity for your business as it potentially provides you with a large number of lenders willing to compete for your business.

However this degree of choice can also provide a problem in finding the right lender as the number of offerings can be confusing.

What to look out for when choosing a lender

There are a number of issues to consider when choosing a lender, which broadly divide into the following key areas:

Services offered

It may sound obvious but the starting point has to be, does the lender provide the service that you want, either factoring (which these days can include confidential factoring, CHOCs and recourse or non-recourse, arrangements), or invoice discounting which is usually on a confidential basis?

But in addition to this there may be additional services that lenders may supply, the main ones being:

Will they provide you with an enhanced level of advance against finished goods stock as part of the debtor funding package?

Many of the factoring and invoice discounting firms will now advance funds against finished goods stock as part of their facility. In practice the advance is made by way of an overpayment against the debtor book, so for example, taking the percentage level of advance up from a nominal 85% to say a nominal 100%, but whatever the value of stock involved, the lender will still regard the debtor book as the core of their security.

To advance against stock, all lenders will need to become comfortable with the value of their security. This means they will need to undertake a detailed audit of the stock and will require you to run a detailed stock reporting system on a live basis to provide regular reports on quantity, value and movement of stock.

As the Inland Revenue and HM Customs and Excise (now combined into one organisation, HM Revenue and Customs) have the ability to distrain against stock for outstanding PAYE/NI or VAT balances, while your landlord has similar abilities in respect of rent arrears, the lender will also want a regular statement of your position in respect of Crown debt and rent payments.

In order to be able to realise the stock should they ever need to, the lender may also wish to enter into an access and priority agreement with your landlord.

Will they provide loans under the Government’s Small Firms Loan Guarantee (SFLG) scheme?

As most UK commercial borrowings are dependent on the assets available to provide security, this leads to a problem in situations which require a loan but where security is not available. To meet this need, the Government, in cooperation with a number of participating lenders, operates the Small Firms Loan Guarantee (SFLG) whereby the government will provide the lender with a guarantee against default by the borrower.

To qualify, your business must be less than five years old with a turnover of less than £5.6m. The government provides the lender with a guarantee for 75% of the loan amount in respect of loans of up to £250,000 and terms of up to 10 years which can be used for most purposes although there are some business sectors which are not eligible.

The cost to the borrower of this guarantee is a payment to the Government of a premium of 2% of the outstanding loan, in addition obviously to the lender’s own charges and interest.

Will they provide a ‘structured loan’ against a package of different assets such as plant and machinery, or property?

Many lenders have branched out into lending against other classes of asset and may therefore be able to provide you with loans against a variety of different business assets.

Advances

Your facility will be based on a percentage advance against approved invoices so you need to look at the headline rate that you are offered, which in the case of contractual debt may be as low as say 50%.

The actual (effective) advance you receive as a percentage of your total debtors can however be significantly less than this nominal headline percentage as the factor may disallow debts over three months old, sales to suppliers, overseas debts, or may set concentration limits where an individual customer’s debts cannot be more than a set percentage of your sales ledger or a credit limit per customer. You therefore need to look at the nature of your debts in the light of the terms offered by the factor and ensure that you will not run into such problems.

As the levels of reserves usually only change monthly in invoice discounting arrangements based on your reconciliation of the account, this can lead to some big swings in your availability.

The lender may also set an overall funding limit on the account in order to avoid becoming overexposed to a client without reviewing the arrangement.

On the upside lenders may allow ‘overpayments’ where they advance more that their normal advance to cover particular circumstances, such as a VAT quarter, so it’s worth asking how flexible they will be (and at what cost).

Charges

You will have to judge how competitive is the cost by comparison with other lenders and so it is usually best to have a small ‘beauty parade’ of say three or so appropriate lenders for your situation to get a feel for what is on offer. Be sure to ensure you understand what services the rate quoted do and do not include. What services are charged as extras?

What minimum charges are built into the offer which means that you will pay for services whether you are using them or not?

Efficiency of factoring collections

Given that the credit control function is part of what you are paying for in a factoring deal and its efficiency is a key determinant of the total cost to you of the deal, make sure you understand what level of service you are buying. Are all debtors to be chased or just a ‘top slice’? How effective is the lender’s chasing? How much time will they spend on your account and how good are they at collecting debts?

Be sure to take references and obtain the lender’s statistics. Ask to meet the operations team who will be handling your account as the sales person you are dealing with now will usually not be involved in the relationship going forwards.

Case study

A company had 500 clients and a strong credit control culture. When it went into a factoring arrangement the lender allocated one person for half a day per month to chase the debtors.

As a result debtor days more than doubled.

Efficiency of operations

Not all lenders are as efficient as others. For example, some lenders are still not set up to collect data on your sales on a same day basis electronically and rely on you to post/fax a schedule of sales against which you can then draw down, thus building a delay (and uncertainty when the post goes astray) into the process.

Many lenders will provide you with live internet access to your account but incredibly some still do not.

Ease of operation

Think about how easy the arrangement will be to operate. Ask to see copies of the statements that you will receive on your account and ensure that these are fully explained to you so that you understand how to follow them once the arrangement is up and running. Try working out how easy it will be to establish how much cash you will be able to draw down day-to-day, as some statements are almost impossible to follow. Ask what level of training and support will be provided to your staff in getting to grips with how this will work.

Contract terms and notice

You have to ensure that you understand what you are committing to. What is the minimum contract length (usually 12 months) and any notice period thereafter (often another three months). What are the termination provisions and any exit penalties if you need to get out early? What are the lender’s collect out charges in the event that the business fails? Be wary of lenders eager to lend into a difficult situation as it is all too easy to make good money out of a failing company in this way.

Other security or personal guarantees (‘PGs’)

In some cases lenders may seek additional security from other business assets or by way of personal guarantees. What, if anything, is the lender seeking and why? Are any PGs limited in value or set to expire at the end of an initial period?

The following table can act as a checklist for comparing lenders’ offers.

Key point lender comparison

    1 2 3
Lender name      
Services      
Factoring / invoice discounting      
Recourse / non-recourse      
Funding      
Advance %      
Total funding line      
Overpayments      
Stock advance      
Other funding      
Restrictions      
Export debt      
Concentration limits      
Contractual debt      
Charges      
Service charge      
Minimums      
Interest rate      
Other charges (eg TTs)      
Collect out charge      
Service levels      
Training / support offered      
Internet access to account      
Email / post submission of invoices      
Average effective funding advance      
Average client retention period      
References available      
Security sought      
Fixed charge on debts only      
Full debenture      
Personal guarantees / other      

How not to choose a lender

Since it is difficult for a business going into factoring for the first time or even looking to switch factors to make a judgement as to the quality of service they are really going to receive, it’s understandable that many will fall back on simply seeking the cheapest quote.

This can be a great mistake as the cheapest quote:

•                Is often not the cheapest in the long run due to hidden charges such as TT costs. Some lenders appear to be in the habit of quoting low rates to customers on the basis that they will make up revenue on such extras. Others try to give more of an ‘all in’ price, which will tend to be higher but in the long run will give you fewer nasty surprises; so ensure you are comparing like with like. When looking at quotes make sure you know what is and is not included.

•                May reduce the flexibility of the arrangement. It is also true to say that as with many things in life you get what you pay for and if for example, you negotiate a low rate of charges with your lender, then you cannot expect a high degree of flexibility over advances if for example you are seeking an overpayment.

•                May actually cost you money in interest charges. If the lender is inefficient at collecting in debts this will result in your borrowing money for longer than you need to, as illustrated below. In this example, a higher sum charged by lender A is compensated for by better services and therefore a lower interest cost from lender B.

  Funder A Funder B
Turnover £1,000,000   £1,000,000
Service charge 0.85%   0.75%
  £8,500   £7,500
Debtor days 45   65
Average debtor balance £123,288   £178,082
Funds out at 75% £92,466   £133,562
Interest rate 5.00%   5.00%
Interest charge £4,623   £6,678
Total cost £13,123   £14,178

Most importantly when considering costs, you will need to ensure that you are comparing like with like as for example factoring can be on a recourse or a non-recourse basis which will obviously attract different rates of charges.

Some companies take the approach of spraying a business’s requirements across the marketplace on the assumption that in doing so they are testing the market and will thereby find the best deal. However since some lenders are simply not interested in spending their time preparing pitches for comparison with a dozen competitors normally on a purely pricing basis, this can lead to these lenders opting not to quote, particularly where they may operate on an ‘all in’ pricing basis which will obviously appear less attractive than a ‘low balled’ price.

It is also worth remembering that any quotes generated at this stage will be based solely on the information submitted to the lenders or website and the actual terms you will receive once the lender has visited and audited may be quite different.

While you undoubtedly need to obtain a number of quotes to test the market, we believe that a better approach is to identify, with expert advice, a targeted shortlist of say three lenders who are likely to provide the service best suited to your needs and then to look at their comparative costs.

Advice on finding a lender

Advisors such as ourselves or business loan brokers can help you to find an appropriate factor or invoice discounter.

Please contact us using the details below for a free, no obligation discussion if this is something you would like assistance with.

Next article: Using Factoring Or Invoice Discounting In Practice

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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