In the second part of our overview from Jeremy Lawrence we look at the the key issues to consider in choosing the best solution for your business.
(See Part 1 for an overview of the main choices in the market for Single Invoice Discounting and Factoring or download the full article from our resources section)
No one wants to pay more than they have to but beware the headline numbers – they can be misleading. The traditional factoring and discounting model usually includes an arrangement fee, a service charge (payable whether or not you use your facility) and interest paid on the money advanced. The interest charge is based on a %age over a standard rate, typically bank base rate. In addition, there can be severe penalty charges if you try to cancel the contract before it has reached its end. Also, don’t forget the administration coast – you will be required to provide monthly reports on the ledger and the performance of your business, regular reconciliations of trust accounts (special bank accounts set up to receive money) and frequent audit visits from your provider – you may find that your accountant cannot deal with all of this and requires additional help.
It is important to take all these costs into consideration. The only cost charged in a spot factoring deal is the “discount” taken by the provider – this is the difference between the face value of the invoice purchased and the amount the factoring company pays for it. The charge is a %age calculated daily from the day you get the money until the day the invoice is paid.
The costs of spot factoring rate can appear to be high because all the costs of the service are built into the headline rate. As there are no add-on costs and no internal administration time to pay for, the comparative cost may be quite low. The costs are also easier to control – spot factoring is only used when it is needed. The invoice can be sold when funds are required and paid off once they are not so the amount of time you actually pay for may be much less than with a traditional factor. In general terms, traditional factoring and discounting will be less expensive in situations where there is a permanent, long term need for working capital finance. A temporary or occasional need for funding will usually be less expensive if spot factoring is used.
The traditional invoice discounting model requires the greatest administrative effort as the provider has to be given ongoing information on the status of their security. There is also an obligation to submit to audit as required by the provider.
Similarly, traditional factoring takes considerable administrative effort in supporting the factoring company’s requirement for information about all elements of the debt book. Where the factoring company takes responsibility for the management of the ledger and debt collection, the administration burden may be reduced but there is of course, a financial cost for this service. With spot factoring, there is no administration burden other than the submission of the invoice for funding. The relationship with the customer remains very much in the control of the client and collection of the debt remains the client’s responsibility.
3) Control of customer relationships
One of the big concerns for many clients is the loss of control over the hard won relationship they have with their customers. The potential risks associated with someone from outside their own organisation being in contact with their customer may be too high to bear. If this is a critical consideration, confidential invoice discounting is the only option available where the customer will remain completely unaware of the existence of the discounter. The downside for this is that the costs and the administration burden are high.
Under the traditional factoring agreement, the customer always knows that his debt has been sold to the factoring company. Although the invoice will be received in his supplier’s name, it will provide the bank details of a third party (the factoring company) on the invoice and statements, reminders and even telephone calls will come from the factor – someone with whom he has no direct relationship. Debt factors sometimes use call centre staff with potentially no interest in the business and whose only concern is getting the invoice paid. The client cannot control the degree of pressure the debt factor may use.
Spot factoring falls somewhere in between these two. Although the customer is required to confirm the validity of the invoice and pay the spot factor direct, rather than his supplier, once this has been done, the spot factor will have no further contact with the customer.
4) Availability of facilities
Traditional factoring companies will consider both the status of the debtor and the potential client’sunderlying business before extending facilities. Where the business is very young or is going through difficulties it is likely that facilities will not be extended or will be severely limited. Although a spot factor will examine the underlying business and take account of its future prospects, the main concern is that the invoice being purchased will be paid. As a consequence, very young businesses can often be funded and distressed businesses can also be eligible provided that there is a realistic prospect of impending recovery.
5) How long do you need the funding
This may be a crucial question. If the need remains significant for the foreseeable future the obligations associated with a long term contract are easier to justify. Traditional factoring is probably for you. However, maybe you should also look at other funding options altogether. If there is a long term need to fund working capital, it suggests one of two things – either your business is growing so fast (and your debtor book with it) that you never expect the profitability of your business to catch up with the need for cash to finance all this new business. Alternatively, if your business is not growing, you should perhaps be looking at the profitability of your business – the implication is that either you gross margins are too low or your overheads are too high. Where the business’s need for funds is spasmodic or occasional, then spot factoring may be attractive as you can dip in and out to meet the specific needs of your business on a day to day basis.
Supposing your cash flow shows that for most of the time funds will be available but that for just a few weeks or months in the year there will be a shortfall. Spot factoring will iron out these spikes in cash demand without the need for long term lending contracts or running costs which you simply don’t need to incur. Once the initial paperwork has been put in place and the facility approved (which typically takes under a week) then you can normally get the cash on an individual invoice in under two working days. It is this ability to pick and choose when you draw funds, together with the speed and flexibility of operating the relationship and the very light administrative burden which can be attractive to many businesses.
Every business is different and has different financing needs. There is no single solution that suits all these different situations. In choosing the right working capital finance model for your business, there are many factors to takeinto account. If the decision seems too hard to make, it may be that your accountant or financial adviser needs to be brought in. But here are a few simple guidelines to think about:
1. If you need continuous long term financial support then one of the traditional models will probably suit you best – being in a long term contract reflects your long term need so the issue of termination will only arise if you are unhappy with the particular provider you have chosen
2. If you need help managing your ledger and are happy for your customer to know about your relationship with the finance provider then Invoice factoring will probably provide the product you need.
3. If it is important that you keep your customer relationships completely in your control, you need confidential invoice discounting – just be ready for the administration burden that goes with that
4. If you only have occasional need for funding or you are not too sure whether when you will need it in the longer term, spot factoring will give you the flexibility to dip in and out of the facility.
5. If you want to keep it simple and have complete discretion over when and whether you use the service, again spot factoring provides this. Using spot factoring can provide a stop gap while you decide which direction your business is moving in.
6. Finally, if traditional sources have turned you down for funding, it is worth speaking to a spot factoring company as there are often situations where they can help when others can’t.
For more information or to discuss your working capital finance needs, call Jeremy Lawrence at Catalyst IFG on 0845 528 0788.