Borrowings for working capital are used to provide short-term, flexible funding to meet your business’s day-to-day financing needs. Traditionally in the UK this requirement has been met through bank overdraft facilities, broadly secured by a charge over the company’s book debts or a personal guarantee from the directors. But as covered in Chapter 7, banks are increasingly reluctant to provide this type of facility, preferring to move borrowers on to debtor based factoring or invoice discounting arrangements and these lenders are in turn also increasingly adding an element of stock financing to their products.

There has always been a degree of stock finance available through trade finance houses, but this has been tailored mainly to funding imports and exports. Some of these lenders are now expanding their operations into more straightforward stock finance. Stand alone stock loans are also becoming available from the banks, but only at the £lm+ level due to the management costs involved.

As will be apparent, many of these forms of finance are therefore becoming interrelated, as the different elements are all linked to the business’s working capital cycle.

This chapter therefore covers:

• debtor based finance which includes factoring, invoice discounting and block discounting;
• trade and stock finance;
• how you may be able to become your business’s own stock funder.

FACTORING AND INVOICE DISCOUNTING

Factoring and invoice discounting are both forms of finance that allow you to raise money directly against your outstanding debtors.

The easiest way to visualise this is to imagine that you can ‘sell’ your unpaid invoices to the lender at their full face value. This lender will then pay you for these in two instalments:

• an initial payment of the majority of the value (the advance, which is usually between 65% and 85%);
• with the remaining balance being paid, less the lender’s charges, once your customer has paid the invoice.

The impact of this is to short circuit the bulk of the normal debtor stage of the working capital clock and so accelerate your cash receipts up to the level of the advance percentage as illustrated in Figure 14.

Since the type of debt that can be discounted can include both goods supplied and services, this type of financing is often used very successfully by businesses such as temporary employment agencies, where the business will need to pay the employees out working on contracts on a weekly, fortnightly or monthly basis, but where its customers may not pay for these staff for up to two months from the date of invoicing. By factoring or discounting the invoices with a lender the business can obtain cash in on invoicing to match the work done and to pay the staff.

Of course the lender does not actually purchase your debt, but will take a first fixed charge over it as security for the advance. As a result, your debtors are then not 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 the initial advance received.

While stock finance is discussed later in this chapter, 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).

Factoring or invoice discounting?

In both forms of finance the lender will provide you with funding known as an advance against the value of the cash due in to you from your debtors. As you forward them new sales invoices and they receive your debtors’ payments on a daily basis the total advance they are prepared to give you will change from day-today. Deducting the previous day’s outstanding advance from the total advance they are prepared to make today gives you your availability, which is the amount of cash you can ask the lender to send to you (or draw down).

While they both involve borrowing directly against the security value of your debtors, factoring and invoice discounting have important differences in how they operate. The most important are as follows.

Visibility and control

In factoring, in addition to advancing you money, the lender also takes over management of your sales ledger and credit control and provides a service in actively chasing in the customers’ payments on your behalf, which can in itself be an advantage if your credit control has been poor. You will also have to place a notice on your invoices that the debt has been assigned to the factor and that your customers should pay the factor direct.

This means, however, that your customers will quickly become aware that you are factoring. They will see the notice and will be contacted directly by the lender about their bills, so factoring is normally a very public form of financing.

As this can cause some businesses concern as to how their key customers are handled, in some cases factors will allow a CHOCs arrangement for key accounts (client handles own customers) whereby you retain control of the contact with the customer. Some have also gone on to develop confidential factoring facilities.

Invoice discounting is usually only available to businesses with turnovers of greater than £lm with a positive balance sheet. It differs from factoring in that you continue to run your own sales ledger and collect in your own debtors. As you are continuing to do the work you obviously retain control of the process and it is therefore also possible to have confidential invoice discounting (CID) which means that your customers will not be aware of the arrangement.

Live and delayed adjustment

As a factor is advancing on individual invoices and is running your sales ledger, any adjustments to the amount of lending they are prepared to advance is immediately tied to the individual invoice movements.

With invoice discounting the lender does not run your ledger and instead requires you to provide a monthly reconciliation of the account on which any adjustments are made to cover the impact of, for example, disallowing older debts. As a result you can find yourself suffering a significant adjustment to the funds available as a single hit, rather than having a daily series of smaller movements which, while they may amount to the same value in terms of cash, may be more difficult to deal with. This difference is likely to disappear over time as one lender has just introduced a service which automatically updates their records daily by linking in directly to your accounting system which avoids large month-end movements. I would expect other lenders to follow suit over the next few years.

Further differences

Factoring and invoice discounting also differ in that as the invoice discounter is not directly in contact with the ledger on a day-today basis, this is perceived as being a riskier form of finance to offer than factoring. Discounters therefore tend to only want to provide facilities to larger businesses, typically with turnovers in excess of £lm, and to businesses with a positive net worth on the balance sheet.

Some of the key differences between factoring and invoice discounting are summarised below:

	Factoring	Invoice discounting
Visibility	Normally public	Normally confidential
Debt collection	Part of the package	You do your own
Adjustments to availability	Live	Monthly on reconciliation
Application	Most businesses with factorable debt	Businesses with turnovers of over £1m and a positive balance sheet

Factorable debt

Not all debt can be factored or discounted, however (and to avoid unnecessary duplication the generic terms factor and factoring will be used to cover both types of funding from here on except where there is a specific difference in how they operate).

As with most commercial debt funding the driving factor for how much can be borrowed is the value of the asset, in this case your debtors, as security. Some debt is impossible to factor as a lender cannot rely on it as security. This includes the following.

• Items sold on a sale or return basis, as the customer can always return the goods and cancel the debt on which the lender has already advanced. For a debt to be factorable there must be a clean sale.
• Even so, any debt which exists on a pay when paid basis as happens, for example, where a customer may be holding a consignment of stock, will not be factorable as the lender cannot necessarily determine a specific point at which the invoice raised will become due and payable, if indeed it ever does.
• The debt must be due from another business (a business to business or B2B sale) as factors are not interested in or set up to collect debts due from consumers (B2C sales). Factors are also wary of sales to government bodies, but some will fund against sales to local authorities or quasi governmental and public sector organisations.
• The other business must be a genuine third-party as factors will all discount any intercompany trading within a group.
• To the extent that a debt is due from a business that is also a supplier to the business the lender faces the risk that the customer will set off (contra) any sums that are due to them as suppliers against the debt due to the business. Any such debts will be excluded from the funding arrangement, or a reserve placed on the account which restricts the drawdown available so as to cover this risk for the factor.

Even having excluded the above, some business debts are still difficult to factor due to their nature, or circumstances which affect a factor’s ability to collect in your debts to repay their lending in the event that your business fails, such as the following.

• Contractual debt for the provision of a service over a long period which involves stage payments such as:
  • engineering contracts where a payment of a third with order, a third on delivery and a third on commissioning is not unusual;
  • construction contracts which may last for many months are a particular problem, as they are normally based on a process of monthly applications which are estimates of the value of the job completed to date rather than invoices for a definite amount. In construction contracts the application has to be agreed with the customer’s architect or surveyors before the final agreed sum becomes payable, normally within two weeks. The bulk of the construction company’s debtor book therefore usually consists of applications which will turn into a debt, but where the value of the debt is uncertain.
• Contractual debt is always difficult to factor; if the supplier fails part way through delivery of a contract, its customer will normally seek to offset the costs of replacing the business and any associated disruption costs (which particularly in the construction industry can be quite creative), against the debt outstanding. As a result there are only a limited number of factors who will provide funding against this type of debt and this is usually at lower levels of advance (say 50% against a more normal level of 75% to 85%, together with a requirement for personal guarantees) as they have less certainty as to both the collectability of any debt and in the case of applications, its actual real value.
• Some contracts, for example for the supply of materials to a manufacturer for use on its production line, may include liquidated damage clauses. These are intended to provide a mechanism whereby the customer can be compensated for any interruption its production suffers if your business fails to supply it with widgets as agreed. These clauses create problems for factors as in the event your business fails, they give rise to the basis for your customers to offset a claim against the sums due to you on which a factor has lent.
• Sales which require extensive after sales service or warranties (such as bespoke computer software) may not be fundable as again the customer may seek to offset a claim relating to the loss of this support or the costs of replacing it against any debt due which the factor would be looking to collect.
• Sales to overseas customers can be a problem as the factor’s ability and cost to collect will obviously vary from country to country. Some factors, such as the banks, are members of international groups and are therefore able to consider funding ledgers with a relatively high degree of international exposure (of say up to 50%), although even here this will involve an assessment of the spread of the ledger on a region by region or country by country basis. Most of the independent sector are, however, focused on UK based debt only.
• Sales to a single or very low number of customers can lead to a problem with what is known as concentration. To avoid having all their eggs in one or very few baskets, factors generally like to see their risk spread across a number of debtors with any individual customer making up no more than 20%-25% of the borrower’s debtor book. However, this is an area where factors differ greatly in their policies. In one case a company went into a discounting agreement with a concentration limit of 25% on any one debtor. Unfortunately it acted as a contract manufacturer for only six customers of which it was usually only working for one or two at a time. As a result, at the end of the first month when it submitted its reconciliations showing the bulk of its debtor book with only two customers, almost 50% of its book was disallowed. In these situations the lender may allow temporary overpayments, but these will usually come at an additional cost.

The starting point for any lender in setting up a factoring facility is therefore an audit of the debtor book, which may be undertaken by in-house staff or subcontracted out to a firm of accountants. To avoid undertaking unnecessary work, factors will often seek to charge for this audit on the basis that the cost will be refunded if you go ahead with the deal. In doing so, they are often testing how serious you are about proceeding with an invoice discounting or factoring relationship. Some will take a view on this and may not make a charge, assuming that they conclude you are serious.

As well as checking for evidence of any of the issues noted above such as concentration, overseas exposure, and any contractual debt or liquidated damages clauses, the auditors will be looking at the quality of the debtor book for security purposes and in particular those listed below.

Aging

Since factors are lending against the security of debts they only want to lend against debts which they are confident will be paid. Where a debt has been outstanding for say three months, almost all factors will conclude that they cannot rely on this debt being paid and will therefore disallow it from their facility. So the auditor will look at the spread of your debtor’s aging. Does your book include large older balances which would be disallowed by the factor? If so why have these arisen and what is the risk that more will arise in future?

Your accounting system will produce an aged debtors’ schedule but this can often be produced on the basis of either the age of the debt since the invoice:

• was issued; or
• fell due for payment.

The age limit to which factors will fund can be 90 days either from the point the invoice was issued or from which it fell due, but they generally prefer the first approach as it avoids any risk of a hidden build up of old debt in the ledger, or of lending against debt that is not immediately recoverable.

In one case a company was selling off its surplus Christmas stock at the end of February. In order to do so they agreed with the customer that the invoice was not payable until the following November. The invoice discounter was allowing debt up to 90 days after the due date. However, this was on the expectation that the company’s normal credit terms were 30 days. When the funder realised that some debts were effectively nine months old before they actually fell due for payment, this led to a significant increase in the reserves placed against the company’s facility and therefore a reduction in the funds available from drawdown.

Contras

In some cases you may be buying from and selling to the same organisation, in which case your customer may have an amount due to them which they may be able to offset against any debt due to you. Factors will therefore disallow debt from their facility in respect of any such potential contras. The auditor will therefore look to match any supplier balances against customer balances.

Credit notes

Factors are wary of the risk that your debtor book can be diluted by the raising of credit notes so that they find themselves having advanced against invoices that are no longer there. The auditor will therefore look at your history of raising credit notes, including the numbers raised, values and reasons, so as to assess the risk.

Bad debt record

What has the company’s experience been of suffering bad debts?

What levels have they run at and for what reasons?

Customer strength

The factor will obviously take an interest in the credit worthiness of your customers, as in the event that the factor needs to rely on their security they will be looking to these customers for payment.

Terms of trade

The auditor will want to see your terms of business, and your paper trail from opening accounts and receiving an order, through to dispatching the goods, obtaining proof of delivery and invoicing, to ensure that you have appropriate agreements in place and systems that they can rely on to support the debts against which they are lending.

Customer’s tools

If you hold a customer’s tools, you can expect some difficult conversations with auditors as to whether this is a good or bad thing in respect of securing payments from customers. Some take the view that this can give rise to customers having a counterclaim, while others take the view that holding a customer’s tools usually gives you a hold over the customer in order to ensure payment.

Advances, charges and terms

The level of advance that you can expect will vary from lender to lender, but in general the banks’ factoring arms have a high degree of captive business introduced through their banking colleagues and therefore tend to be more conservative than the independents. As a guide, you might expect the bank factors to advance say 60% to 85% against a normal book, whilst the independent firms may range between 75% and 90%. They will in addition consider providing top-up facilities against stock or agreed temporary overpayments of say up to 100% to cover specific items such as a peak requirement at a VAT quarter, or exit penalties imposed by another lender.

These advances are all at nominal levels, as all factors will only advance against approved debt, which is to say your total debtor book less the debt that has been disallowed as a result of:

• aging when normally debt of over 90 days will be disallowed; and
• reserves placed against the accounts to cover any:
  • supplier contras;
  • balances in excess of agreed concentration limits;
  • intercompany trading; or
  • individual debtors that the lender won’t fund for whatever reason, such as overseas debtors.

As a result of this disallowed debt, your effective advance (ie the funds available that you can actually draw down from the factor) will often be significantly lower than the percentage advance you have agreed with the lender. And be warned that in situations where a business is in difficulty, one way of managing a factor’s exposure is for the factor to take a more aggressive stance in disallowing debt or placing either specific or general reserves on account so that the percentage they have advanced against the total book reduces. I have, for example, worked with companies where as a result of this sort of approach by the factor’s operations department the effective advance has dropped to as low as 20%.

The costs of factoring will include two main elements.

• A service charge which for factoring can run at 0.5% to 1 % of turnover. Factoring tends to be more expensive than invoice discounting as the charges include the cost of providing the sales ledger function of the facility, and the number of customers and the number of invoices being issued will therefore come into the equation for determining the costs. These charges are very visible and one of the reasons why factoring has a reputation for being expensive. However, when you’re comparing the cost of factoring with other sources of finance you will need to take into account any savings you may be making by outsourcing your credit control function. When comparing factoring with the cost of normal bank facilities, be sure to take into account any management charges that your bank is imposing.
• Interest costs, which will be quoted at a rate over base and which should therefore be directly comparable with interest rates from other types of lending.

There are, however, some other costs to take into account which include:

• any initial audit cost as discussed above;
• a take-on fee to cover the administrative costs of setting up the arrangement;
• credit insurance costs where the lender may insist that you obtain insurance cover on some or all of your debtors;
• transaction costs such as telegraphic transfer fees (TTs).

Since it is difficult for a business going into factoring for the first time, or even looking to switch factors, to make a judgment 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 is often a mistake as the following may apply to the cheapest quote.

• It 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 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.
• It 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. If, for example, you negotiate a low rate of charges with your lender, you cannot expect a high degree of flexibility over advances if you are seeking an overpayment.
• It may actually cost you money in interest charges if they are inefficient at collecting, resulting in your borrowing money for longer than you need to, as illustrated below (ignoring VAT), where a higher sum charged is compensated for by better services and therefore a lower interest cost.

	Funder A	Funder B
Turn over	£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 factoring can be on a different basis.

• A recourse basis, where in the event that a customer does not pay, the lender can recover the funds they have advanced to you from your current availability, leaving you exposed to the impact of the bad debt.
• A non-recourse basis, where if a customer fails to pay a debt where there are no grounds for dispute; this is the factor’s problem not yours.

Obviously in non-recourse factoring the lender is taking a much greater risk, or will be bearing an expense in insuring the debt, which will be reflected in the price of the service.

What you will usually find is that the factor will advise you of a credit insured limit for each customer, which will be the figure up to which non-recourse applies. So if you have three customers who do not pay, the result would be as shown:

Customer	Debt due	Credit insured limit	Impact of failure to pay on your facility
A	£10,000	£15,000	The factor’s ‘insurance policy’ pays you out for the debt so you suffer no reduction in facility and the factor then pursues recovery in the normal way.
B	£10,000	£5,000	The factor’s insurance policy pays you out to cover the first £5,000 so that there is no loss of facility in respect of this, but the factor will claw back the advance made in respect of the further £5,000 in excess of the credit insured limit. The factor will then look to recover the full amount from the debtor and if they do so they will restore the funds to your account.
C	£10,000	£0	The factor will deduct the entirety of the advance made against the £10,000 debt which will reduce the funds available to you.

The factoring and invoice discounting market

This has been a rapidly expanding market over the last few years with between 50 to 60 active factors and invoice discounters operating at the time of writing. There is therefore a wide variety of lenders falling into three main categories.

• The main clearing banks’ own and branded firms which 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 who may well be owned by smaller 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 an number of asset based elements, including property and plant and machinery loans as well as stock and debtor finance. They 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.

For reasons that have already been covered, 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 where 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 have to try harder, typically offering better advance rates and more flexibility.

If you are seeking to transfer from one factor to another you need to be aware that there is a protocol agreed between the firms and that the new lender will seek an inter-factor reference from the old lender. The particular issues that they will be looking for are any suggestion of either of the two great sins of factoring.

Pre-invoicing

The fresh air invoice, where cash has been raised against an invoice where no goods have in fact been supplied, is the most obvious fraud that factoring arrangements (and more particularly confidential invoice discounting where the lender is not in contact with your debtors) are open to. The lender will guard against them by holding regular debtor audits and contacting your customers to verify invoices. Any suggestion in a reference that this has taken place can be sufficient to sink a deal.

Diversion of cash

In a factoring arrangement the customer will be instructed to pay debts direct to the factor. On occasions customers will still make payments to the company direct. Where this happens it is your responsibility to pay the cash over to the factors as otherwise you are still borrowing funds in respect of an invoice which is no longer outstanding. If you do not make such a payment you are actually diverting cash that is due to the lender. Again, invoice discounting arrangements, where you are responsible for collecting in the cash and then paying it into a trust account for the benefit of the lender, are much more open to this form of abuse.

Penalties

If you are seeking to transfer before the end of your current contract, as discussed below, you are likely to be liable for penalties. In these situations there may be a deal that can be negotiated between the incoming and outgoing factors to mitigate these, or if not, the new factor will typically seek to provide some assistance through either an enhanced initial drawdown, or in some cases a sharing of the cost of penalties in order to win your business.

Issues to consider when choosing a factor

This chapter will hopefully have given you a better idea of some of the things to consider when choosing a factor or invoice discounter. Obviously you will need to decide first whether this type of debtor based finance is appropriate for your business, and if so whether you are better off with factoring or invoice discounting.

• With factoring you will lose control of how your customers are chased for payment unless you opt for a CHOCs arrangement. With invoice discounting this is under your control.
• Your facility will be based on a percentage advance against approved invoices. The actual (effective) advance you receive as a percentage of your total debtors can 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 individual customer’s debts cannot be more than a set percentage of your sales ledger or credit limit per customer. You need to look at the nature of your debts and ensure that you will not run into such problems. As the levels of reserves only change monthly in invoice discounting, based on your reconciliation of the account, this can lead to some big swings in your availability.
• As the advance is tied directly to invoicing, debt based finance is well suited to fast growing companies as the financing automatically expands as the business grows, reducing the danger of overtrading.
• However, as the facility is tied to sales volume, if sales fall, so does the funding available (which may be just the moment that you need finance the most).
• Once you have this type of facility in place, it can be extremely difficult to get to a position where you can exit the arrangement.
• There is still a stigma attached to factoring in some circles as it has been seen as financing of last resort. However, as banks have moved more customers to this form of financing (and it becomes a normal part of almost every MBO/MBI transaction), this stigma is disappearing (and of course is avoided with confidential invoice discounting).
• Finally, what happens if you get into difficulty? As already discussed you may find that the factor will look to manage its risk by reducing its effective advance, sometimes to a level which can lead to the strangulation of the business. In these circumstances invoice discounters will look to move your account onto a factoring arrangement as a way of giving them a much closer understanding of the exact profile of your debtors and hold much more detail about the outstanding book in case they have to undertake a collect out. Most invoice discounting and factoring arrangements have built in a scale of charges to cover collect out situations where they have to recover their money from a business’s debtors following its failure. In practice this means that the lender’s exposure is often limited, because they have successfully restricted drawdown prior to a failure. This then gives them scope to recover their collect out charges which can be highly remunerative.

Some key questions that you need to ask in respect of any particular provider’s offer follow below.

• 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 or 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 chasing? How good are they at collecting debts? Be sure to take references and obtain their 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. 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. They 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.
• Does the lender suit the nature of your business and for example its level of debtor concentration or overseas sales? How flexible are they and what other lending are they providing you with? Will they provide you with an enhanced level of advance against finished goods stock as part of the debtor funding package?
• What additional security are they asking for in terms of personal guarantees?
• How competitive is the cost and what does it include? How does it compare with other offers you have received?
• What are you committing to? What is the minimum contract length (usually 12 months although one lender has an ‘easy in, easy out’ facility designed for situations where you may only want or need a short-term arrangement) 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 level of minimum charges are built in which may mean you end up paying charges even if you do not draw down cash?
• How easy will it be to operate? Ask to see copies of the statements that you will receive on your account. 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.

The information that Creative Business Finance Limited seek when arranging an introduction to an appropriate funder is set out in Figure 15.

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. However, 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, you may 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.