As a cash flow tool, the image of factoring has changed.
It’s no longer seen as a desperate move by a badly managed business. Bill Shew looks at how and when a business can use factoring to create cash flow advantage, and how and when it can’t.
Factoring has had a chequered history in Australia. Until the mid to late 90s it was seen as the last resort of a poorly performing business. In those days the cost of obtaining cash flow this way was in the range of 20 percent.
Today, factoring, like invoice discounting, has become a legitimate way for growing businesses to obtain loan funding without the need to provide security over physical assets of the business or personal assets such as the home.
Financial institutions are recognising the importance of offering SMEs an alternative means of funding that does not include security over fixed assets. Factoring and invoice discounting are becoming common products throughout Australia, with a number of banks restructuring their service offerings to provide such forms of cash flow lending to all levels of business regardless of their size. This is driven by the demands of the market and the increasing sophistication of small business. However, Australia is still relatively immature in the area of providing invoice discounting and factoring as a form of finance, compared with, for example, the UK.
How Factoring Works
How does factoring work and how does it differ from invoice discounting? Factoring is similar to invoice discounting in that the financial institution provides working capital funding, usually up to 80 percent of the book value of the debtors, secured over the book debtors only.
Factoring is different from invoice discounting in that the financial institution ‘acquires’ the debt from the business and may actively collect those debts from the customer. With invoice discounting, the financial institution provides loan funding secured over the debt. The business continues to collect against invoices and meet the loan repayment obligations.
The risk attached to factoring is considerable and is reflected by its cost. While the cost of funds through factoring is no longer in the range of 20 percent, interest rates are generally higher than overdraft rates (usually two to three percent) and substantially higher than debt secured against fixed assets, demonstrating the risk that the financial institution attaches to this form of debt.
It’s important to note that a number of service contracts with customers may have a ‘non-assignment’ clause that does not allow the service provider to assign the debt in any way, whether it be through a factoring arrangement or invoice discounting. The customer would be required, under the contract, to give consent to allow for this assignment to occur. In such circumstances the customer may be made aware of the lending arrangement. This is not the case in all circumstances. Our experience indicates that the issue of non-assignment generally applies to long-term service contracts where a key service or product is deliverable over a period of time. Normal trade sales through retail or wholesale may generally not be affected.
Using Factoring
Because the cost of debtor financing and factoring is higher than other forms of secured funding, you need to carefully consider this as an option. It is often used where all other forms of security have been exhausted, or it is kept in reserve as an option when the business needs to fund rapid growth opportunities and lacks the working capital to realise them.
Factoring and invoice financing have their benefits where customers are slow to pay over the 60- to 90-day period. But it is important that you are confident that these customers will eventually pay. The bank will be looking for assurance that the debtors will pay. Financial institutions will look for a track record of ongoing performance and maintenance of a healthy debtor’s book.
The larger and healthier your accounts receivable are, the better your chance of getting this form of funding. If there are significant bad debts, questionable clients or old debts, then the financial institution will not lend against these sums. Given the cost of funds, if your debtor’s book is strong and cash collections are within 45 days, then debtor financing will not provide any real additional funding benefit and will in fact cost the business through interest and administration charges. So, if business owners have a comprehensive understanding of the pros and cons associated with it, factoring is suitable for those SMEs without assets to secure or those who don’t wish to put their house up to fund the business for a short period of time.
* Bill Shew is a director of Business Owner Services with Grant Thornton (http://www.grantthornton.com.au).
