Asset-based finance, also known as asset-based lending or funding is essentially a business loan that is secured by collateral. Asset-based finance is usually secured by inventory, accounts receivable, or other assets that the business owns like machinery and vehicles.
As these are secured loans, interest rates tend to be lower than unsecured loans such as overdrafts because the collateral can be liquidated by the lender if default on repayment occurs.
This guide will focus on the role of one particular asset-based finance model; Invoice factoring and discounting in modern business today.
What is Invoice Factoring?
Invoice factoring is an asset-based financial product that uses the value of a business’s outstanding sales ledger invoices (money which is owed by their customers) to raise cash in the business. If a business sells products and services on payment terms such as 30 days or longer but needs cash immediately to pay for a specific business function, then factoring might be an option.
The factoring provider will carry out due diligence on the sales invoices before lending a percentage of the total sales ledger value, based on their findings. The responsibility for the management and collection of those invoices is then passed to the factoring provider. The sales ledger debtors are then informed that this arrangement has taken place, giving details of who the factoring provider is.
What is Invoice Discounting?
We are often asked, what is the difference between invoice factoring and invoice discounting? Well, the truth of the matter is they are very similar in the way that sales ledger invoices are used as collateral to raise cash in the business. However, instead of the credit control function being outsourced to the factoring provider, it is kept in-house and is the responsibility of the company’s accounts team to collect the debt as usual. In this instance, the debtors do not have to be informed of the arrangement.
What happens if a factored invoice cannot be collected?
Another great question often asked when factoring for the first time is “what happens if a factored invoice becomes a bad debt and cannot be collected?” The answer is that factoring can be set up on a recourse or non-recourse basis.
This is usually arranged with the factoring provider during the application process. A recourse basis means that if the debt becomes unrecoverable, the factoring provider can recover the funds from your business. However, if your factoring has been set up on a non-recourse basis then the factoring provider is exposed to the bad debt instead of your business.
The caveat here is that as long as there are no grounds for a dispute over payment by the debtor, this arrangement can be honoured by the factoring provider. Obviously, in the second instance the risk is placed firmly with the provider and as such the cost of factoring may be higher than if you take the recourse route.
Factoring Vs. Overdraft?
There are many good reasons to use invoice factoring and discounting as an alternative to loans and overdrafts. By far the best reason to use it is that the arrangement is so flexible. You can adjust the amount you factor on a month-by-month basis in line with the level of sales ledger invoices you have on your books.
It helps you to grow as a business safely without fear of overtrading. For instance, you have just taken a very large order from a trusted client but you are going to find it difficult to cover extra wages and raw materials required to fulfil the order. So rather than taking on a costly loan or stressing your overdraft limit, you could factor the invoices you have on your current sales ledger to raise the much-needed cash to buy materials and pay the extra wages required to fulfil the order.
Factoring also helps to keep a stable cash flow in the business. Predictable cash flow in any business is what everyone strives for. That way you can plan your business expansion, safe in the knowledge that you are getting a steady regular income without any shortfalls.
Another great advantage is the amount of cash you can raise compared to the value of the asset. In the case of invoice factoring and discounting this can be up to 85% of annual turnover. Compare that to conventional bank lending of up to 50% of annual turnover and you will see why it might be the right choice for some businesses. What’s more, because of the due diligence checks made on the asset (your sales ledger invoices) it is often the case that you can get a much lower interest rate than conventional loans and overdrafts.
Preparing for Factoring
Once you have decided that invoice factoring might be an option for your business you will want to find a provider that fits your business profile and can deliver the best possible service to you. You may want to use a search facility like ours to do the leg work and find the most appropriate provider out of the 50+ factoring providers in the marketplace today.
For us to do that, we need to know a few basic facts about your business. That is why we have created a short questionnaire for you to use. We can then use your answers to match you to the most appropriate factoring provider. As a consequence of this, you get a much more favourable funding level, and interest rate because the factoring provider has got to know how you and your business work.
We have included the questionnaire for you in the latter pages of this guide. Write your answers on the blank pages provided and return them to us. We can then start the search process and arrange for a provider to come and review your funding arrangements.
How can I ensure I get the best deal when factoring?
Other than using our search facility which results in improved customer service, interest rates and borrowing level; there are certain things you can do as a business to ensure you get the best deal possible.
What I do not recommend you do is to play off one factoring provider against another. This may work on a short-term basis but only works to eventually damage relations between you and the providers and you end up with a reduced pool of providers willing to work with you and a reduced level of service overall.
What I do recommend you do is work to reduce your overall working business risk and improve your credit score. These are the two things that make a big difference to the interest rate and funding level you are offered. Business risk is measured by the type of industry you are operating in and the strength of certainty that your sales ledger invoices will be paid. This in turn is related to the quality of your customer’s credit scores. So in essence if you can optimise your business’s credit score, and the overall credit score of your client base, you will vastly improve the level and cost of funding you are offered.