A company needs to have good cash flow to survive. That means having enough spare cash to pay for recurring costs such as wages, utility bills, rent and rates. It also means having spare money to pay for supplies. Often a company is left waiting for an invoice to be paid from a customer until it can pay its bills. This is a cash flow problem. The solution is for a company to find a way to finance its operations.
Typically, a company balance sheet takes monthly sales and deducts direct costs to determine gross profit. Direct costs refer to costs incurred to make a product or to offer a service such as supplies needed to produce inventory or wages needed for staff that provide the service. Office overheads are then deducted to calculate net profit.
Annual net profit might show a healthy margin of gain. However, during that year a company can run out of funds to pay for monthly direct costs and office overheads. This is because there is a delay between providing goods or services and being paid. An invoice specifies in its terms of trade the period of time a customer has to pay. This is often 30 or 60 days. Some customers will pay promptly, while others will be late paying and will need chasing up.
It is in this context of cash flow issues that a company will look to find a funding arrangement to keep paying the bills until customers pay for the goods and services they have bought. The options for funding arrangements are:
- Share Capital. A company looks to raise cash by selling shares in the company.
- Directors’ Loans. Directors loan money to the business for an agreed period of time.
- Mortgage. If a company has a property, it can obtain a loan using the property as collateral.
- Bank Overdraft. A company can arrange with its bank to be extended a line of credit through an overdraft facility.
- Bank Loan. A company borrows from its bank and agrees to repayment of the loan through monthly or quarterly instalments.
- Hire Purchase and Leasing. A company can buy its machinery and equipment using HP or leasing. In both cases the machinery and equipment is paid for in monthly instalments.
- Finance. There are three types of finance available: trade finance, invoice finance and stock finance. In trade finance a trade financier will buy supplies for a company and accept delayed payment for a fee. In invoice finance, a company sells its ledger of receivables in order to obtain early payment. This can be done through factoring or invoice discounting. In stock finance a company uses inventory and raw materials as security to obtain a cash payment.
All of these options involve costs. Money is lent at a certain interest rate. There are also other charges associated with bank loans, mortgages, hire purchase and leasing. Directors risk their own money in the case of a directors’ loan. Selling shares means new voices are bought into a company and dividend payments are diluted. Bank overdraft facilities can be removed or reduced if the bank has concerns over repayment. Invoice finance is only available for B2B businesses. All the finance options involve recurring fees, and might be available only if the financier deems the invoices or stock to be suitable security.
In short, there is a lot to consider for a company looking to raise money to meet cash flow requirements. Borrowing money means paying interest on the loaned amount. In economic recessions interest rates invariably go up to combat inflation. Many companies will often use more than one type of funding arrangement.
Costs of Invoice Finance
A company has looked at the funding options available. They don’t want to sell shares or invest directors’ money. They don’t want to put up property as security. They have come to the conclusion that invoice finance is the best way to raise funds.
Firstly, they will have to pass a suitability test as not all business sectors are served by invoice finance; moreover, not all invoices are deemed as suitable for factoring or invoice discounting.
If these initial checks are cleared there are three types of costs associated with invoice finance:
- Cost of funds. This is also called the ‘discount charge’. This is a fee for borrowing. It is calculated as a percentage of the amount of money borrowed. The rate is an agreed percentage higher than the bank base rate.
- Service Charge. This is a fee for running an invoice finance facility. It is usually calculated as a percentage of a company’s annual turnover.
- Additional Charges. These charges include for refactoring (this is a fee for invoices that remain unpaid for longer than expected periods of time), for administering money transfers and for making changes to the invoice finance facility.
Benefits of Invoice Finance
The reason why invoice finance is often seen as the best solution to the problem of cash flow is because this form of funding arrangement has several benefits. An invoice financier not only has underwriters with cash to invest, but also expertise especially in the area of credit control. This means they are adept at examining the sales ledger and spotting outstanding invoices that might be paid late or not at all. It also means an expertise in chasing down debts. The value that an invoice financier can bring to a company is such that often they are employed just for these services (in ‘service only’ facilities) and not to organise prepayments on unpaid invoices.
Non-recourse factoring and non-recourse invoice discounting also offer the additional benefit of protection against bad debt. If an invoice remains unpaid because, for example, a client goes insolvent then the invoice financier cannot reclaim the money provided as an early payment on that unpaid invoice.
In Summary
It is common for a company, especially early on in its operating history, to experience cash flow issues: whereas wages, bills and office overheads have to be paid monthly, money from sales may take months to make its way into the company account. It is this delay that can impede a company and drive it into financial difficulties.
Faced with a cash flow issue, a company has a number of options to cover the shortfall in available funds. One option is invoice finance. While there are a number of costs associated with both factoring and invoice discounting, for many companies the pros outweigh the cons. An invoice financier will provide sales ledger management, debt management and ongoing access to funds for cash flow. In the case of non-recourse factoring and non-recourse invoice discounting an invoice financier also takes on the risk of non-payment of an outstanding invoice. These are all key benefits that can make the difference between a company succeeding and failing.
