What are they?

What to do when you need to use factoring or invoice discounting What are factoring and invoice discounting? They are both forms of finance that allow you to raise money directly against your outstanding debtors as a way of covering a ‘funding gap’. The easiest way to illustrate how this funding gap arises, and how these forms of ‘debtor based’ finance can fit in, is by way of looking at a couple of typical business situations in both a service sector and a manufacturing business.

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Why your business needs cash – the funding gap

Imagine, for example, that you run an agency supplying temporary workers that you place with a customer for two weeks at a time.

At the end of the fortnight your staff will want to be paid (let’s say they cost £500) and you will be able to raise an invoice to the client for their time (let’s say for £1,000, ignoring VAT). The only problem is that in reality your customer is not going to pay immediately but will typically take say eight weeks to settle your bill.

This leaves you with a gap between the time when you have to pay your workers their £500 and the time when you receive the cash from your customers for the job.

So this ‘funding gap’ has to be filled from somewhere, either by cash invested by you into the business by way of share capital; or directors’ loans; or by having left profits in the business; or by borrowing.

The same issue would arise if you were running a manufacturing business where you will normally receive a period of credit from your raw material suppliers (let’s say that on average you can take eight weeks to pay).

However, you might hold on average 21 days worth of raw material stocks, 14 days of work in progress and 21 days worth of finished goods stock which means that by the time you actually come to sell the goods that those raw materials have been used to make, you are due to pay your supplier.

But you will suffer from the same problem as the temporary labour agency in that you are likely to be selling on credit so again it will be say eight weeks before you receive the cash in giving you a similar funding gap.

Obviously you can look to manage your ‘working capital requirement’ to minimise this gap and therefore your funding needs.

You can, for example, keep your investment in stocks to the minimum practical level that your business can manage on; while also being as efficient as possible at collecting in payment from your customers to minimise the cash tied up in debtors.

Overtrading and the advantage of flexible funding

Incidentally, looking at your business’s finances in this way also shows why having sufficient flexible funding is so vital for growing businesses because it demonstrates how and why access to cash is needed to support any given level of your business’s trading.

From this you can also hopefully see that if your business’s level of trading increases, then the level of funding it will need will increase to match.

However most bank facilities are relatively inflexible as they are set at a particular level for a period of say a year, usually based on an assessment of a business’s funding requirements and available security at the time they were agreed (which will generally be based on say 50% of your ‘current’ debtors), and can therefore be difficult to adapt to cover the rapidly changing requirements that occur in a high growth business.

Businesses which expand faster than the level that their access to cash can support, a problem known as ‘overtrading’, often fail as while they are trading profitably, they simply run out of cash to pay their suppliers.

Because the funding available through debtor based finance is based on your sales and debtors, it is therefore an ideal way for high growth businesses to avoid this problem. As your level of turnover and therefore the value of your outstanding debtors grow, debtor based finance automatically provides you with access to more cash to match.

How debtor based funding works

The easiest way to visualise how these forms of finance work is to imagine that as soon as you have made a sale to a customer, you can then immediately ‘sell’ your unpaid invoices to the lender at their full face value. This lender will then pay you for these in two instalments:

  1. an initial payment of the majority of the value (known as the ‘advance’, which is usually between 65% and 85% of the gross invoice value, ie including VAT if applicable);
  2. with the remaining balance being paid over, less the lender’s charges, once your customer has paid the invoice.

The impact of this is to ‘short circuit’ your business’s wait for the receipt of most of the payment from your customers as the lender is providing you with the bulk of payment immediately through the advance at the point of sale.

Of course in reality the lender does not actually purchase your debt but will instead take a first fixed charge over them as security for the advance.

As a result, your debtors will not be available for your bank to use to secure an overdraft facility. Completion of a factoring or invoice discounting deal therefore usually involves paying off your overdraft out of an initial advance received from the lenders ‘take on’ of your existing debtor book.

While stock finance is discussed later in this section, it is worth noting at this stage that some invoice discounters will also take finished goods stock into account and can then offer higher levels of advance against invoices (sometimes exceeding 100% of your debtor book).

Next article: How Does Factoring And Invoice Discounting Work?

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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