With the rise in Invoice Discounting providers I wanted to point out the full implications around this offering. I work with small businesses and I have seen this work both very badly and very well. The key is to go into this facility very clear on what the expectations are from both sides.
More and more small business owners are looking at invoice discounting. This option allows you to be given forward funding against your sales invoices. The funding is paid to you as soon as the invoices are notified to the invoice discounting provider. Without this funding arrangement in place you would need to wait for the customer to pay you.This may limit how quickly you can grow your business. Many of the points covered below apply also to invoice factoring and for more specific advice about this service please read my Invoice factoring article here.
When Should You Consider Invoice Discounting as a funding option?
The main driver for considering this option is when you are granting your customers credit terms. This would normally be any time after you have to pay out for the raw materials to fulfil that order. Many newer businesses will turn to this option to be able to work with larger customers. Such customers include Corporate or Government owed companies. They will not accept any shorter terms than 30 days credit. Some, due to their corporate style payment processes may not actually deliver the cash into your bank account until 60 days plus.
If you do not have a cash reserve to cover this ‘working capital’ requirement, you will need to look to alternative sources of funding. Invoice discounting is where the funding is secured against the invoices that you raise. Hence if there is a long lag between you delivering your service and the customer paying you, Invoice Discounting could be a good solution.
When you take up an offer for Invoice Discounting it is so important that you realise what you are getting in to. It is important that you check that you can fulfil the providers requirements. It is also important that you fully understand what limitations are placed on your funding, before you enter into the agreement. In this way you can take the necessary actions required so that these limits or conditions are never breached.
First though let’s look at the key terms that will be included in your offer.
What is Included in the offer?
Your offer will normally be made to you in terms of the following key figures:
- Credit limit: You will be offered a credit limit on how much advanced funding you will be allowed. Be sure to consider this carefully. Think about your projected sales moving forward.
For example, if you normally raise £100,000 worth of invoices a month, you may be set a credit limit of say £200,000. This means that if your customers pay you on 60days credit terms you will normally require funding of £200,000. This equates to 2 months’ worth of invoices.
E.g If you succeed in securing a new, large deal for £80,000 then this will be in addition to your normal requirements.
Often an increase in credit limit will need prior authorisation and will not always be guaranteed. It will depend on the credentials of the new customer. You will also incur additional costs for an increase in credit limit.
In summary then, don’t assume that you will be able to pull down unlimited funding. .Limits are in place to ensure you are kept within certain boundaries. Negotiate the credit limit wisely so that it considers any projected growth.
2. % of Ledger Funded.
An invoice discounting provider may not grant funding against all your customers. This may be due to poor credit ratings etc. However, they will require you to allow for all the cash payments from customers to be passed through them. I.e. they get all the cash first. This is referred to as a Full Ledger.
The % of the invoice that they will advance you is normally 90% to 95%. The remainder of the funding will be released to you on full payment by the customer. In some instances, you could find that you have not received funding on a customer. The payment from the customer has been received, but your overall funding has been withheld. (Reasons your funding can be withheld is covered later.)
This is because your availability of funds is calculated based on one big pot. Availability of funds is defined as the funds that are available to you to draw down in cash. They are not specifically tied to individual customers.
3.Agreed Payment Terms on Customers.
The Invoice Discounting provider will set an amount of time to allow for your customers to pay you. This will normally be 90 days but can be negotiated. if you are in an industry which normally deals with longer payment terms remember to highlight this.
If your customer is very late in paying, you will need to wait for this amount to be released.
Hence If an agreed credit term of 90 days has been set for your customers and one customer still hasn’t paid after 90 days, the amount that has been advanced to you will be withdraw. It won’t be that you will need to pay this money back. Funding will be withheld until the equivalent amount has been clawed back from the new invoices raised. This may result in there being a period when you have no funding available to you.
4. Service Fee:
This is the fixed amount you will pay based on the value of invoices being funded. This figure is paid regardless of the amount of funding you draw down. This is a good comparative figure to look at when deciding which Invoice Discounting Provider to use.
This is the rate of interest that is charged on the amount of funding you are using. This is normally worked out on a daily interest rate.
It is important to moderate how much funds you are drawing down, especially if any excess cash you have in the bank is not earning you any interest.
An invoice discounting provider will often also ask for a director’s personal guarantee.
It is important to check from the onset if this is a requirement.
This will be against any funding that is granted. Therefore, if you default on any of the amounts due to your funder, they will pursue you personally for any of your personal assets. Be sure that you are comfortable with this before you sign up.
Now that all seems clear I hope! But what about the things that are not explicit in your offer? Here are 4 areas you won’t necessarily be told about in your offer letter.
The Invoice Discounting provider will normally require you to use their own portal. They will request that you report back to them some key monthly figures. These figures will mean that your sales ledger management needs to be absolutely tip top. If you do not report back to their deadlines, you could have your funding stopped. The deadline for reporting is normally 2 weeks after the end of the month.
The reporting back requires a reconciliation to be carried out between your ledger and their ledger. This is standard bookkeeping practice; however, you will be surprised on how many general misallocations are made in the bookkeeping process. This can lead to a mismatch between figures. The aim is to match what the funder believes Is the value of your sales ledger to what you have on your own accounting ledger. Where balances don’t agree, a reconciliation will need to be carried out; invoice by invoice, customer by customer, payments by payments.
It can be a lot of work depending on how many invoices you raise per month, how your payments come in and the level of detail is given to you on remittances.
So, have a think about how well you are currently doing in terms of getting your month end accounting figures out. Is it taking more than say 2 weeks to see a draft Profit and Loss? This could indicate that you do not have the in house capability to deliver the reporting requirements. This needs to be sorted out first, before you embark down this option.
How good are your invoicing processes? Do you have to raise a lot of credit notes due to incorrect initial invoices? Do you get a lot of returns due to damage or delivering an unsatisfactory product or service? If so, then this may lead them to cutting your funding.
Invoice Discounting Providers will normally set a % limit of credit notes than can be raised per month. For example, a 2% limit would mean the value of any credit notes raised in any month must not exceed 2% of the value of your monthly invoices.
It is important for you to check that this is not something that is happening in your business. You should try to sort out why a high level of credit notes are being raised. Sometimes in fact where goods are returned, it is better to offset the credit against future invoices instead of raising a credit note.
3.Consistently Bad Payers:
It may be that one or two of your customers are consistently bad payers. This again is normally prevalent with bigger companies who have poor in house payment processes. They always pay. But they always pay late!
To you they are a good customer because they do always pay and they spend a lot of money with you.
If this is something that you experience, you will need to make this clear from the onset, to your invoice discounting provider. If they are not able to accommodate this without cutting your funding, it may be that this is not going to work for you.
An invoice discounting provider will normally set dilution limits on the mix and size of your customers. This is to spread the risk of customers defaulting on payment. Hence if you have 10 customers but 50% of your income comes from only 1 customer, you are unlikely to get these funded against. The normal limit for any one customer is 20% to 40% of your sales ledger balance. Be sure you ask what this figure is and work out if any of your customers fall outside of this range. Again, this could be a potential show stopper if you cannot get these customers fully funded.
Thinking forward, if you are planning for a large contract with one customer, is this going to materially change your dilution and bring you outside of the limit imposed?
Finally consider your in house credit control. Is it a strong capability or an afterthought? Where invoices breach the 90-day limit or where customers decide their cash flow constraint are more important than yours, (!) then how vulnerable will you be to a temporary limit on your funding whilst you wait for the customer to pay?
So, there we have it, the good bad and the ugly of invoice discounting offers. Be sure you are aware of all the expectation around the offer from your funding provider and proceed only when you are confident you can deliver you side of the bargain. In house finance capability is a must to ensure that this option runs smoothly and it delivers the working capital advantages you are looking for.
If you would like to speak to me about how I work with your inhouse finance teams. Focusing on timely, accurate and efficient finance reporting please contact me here.