It is said that the great trading empires of the Phoenicians, the Romans and Elizabethan England all used a form of invoice factoring to finance their expansion. For thousands of years, there have been bankers willing to advance loans against unpaid sales invoices.
Invoice finance is now the preferred method of business lending, outstripping overdraft lending to SMEs and suiting an increasing number of businesses in the service-led economy where debtors are often the only significant assets. It is regarded as the optimal way to fund business growth because lending is directly linked to, and secured on, their customer’s sales ledger.
However, although the way we do business in the 21st century may have changed, the guiding principles that lenders use to decide how much they lend, to what businesses and for what return, remain largely unaltered.
Technology has brought some science to the financial analysis, yet the lender should still be asking the same questions as ever, because the five principles that underpin a successful funding relationship are as true now as they were centuries ago.
Below, I examine these values and show how they guide the lender and the borrower in understanding the roles and responsibilities each party bears within an invoice financing partnership.
At the heart of every business are its people. Understanding who they are, their motivations, experience and track record is essential, and this goes well beyond the usual “Know your Customer” (KYC) and anti-money laundering checks.
Essentially, it boils down to how well the senior management run the business and whether they can be trusted.
There should be a relationship of mutual trust and respect between the lender and management, and confidence that the customer can be relied on to provide accurate information about their business. A history of success, respected status in the community and an “open book” approach to due diligence can be more valuable than any amount of personal indemnities from less reliable Directors.
Understanding what the business does – its products or services – is fundamental. Successful lending against an invoice requires an appreciation of what could lead to it not being paid on time, or at all. Analysis of historic credit notes or bad debts will give an indication of the levels of unpaid invoices, and the simpler the business, the lower these levels tend to be. Disputes and uncollected invoices need to be monitored throughout the lifetime of the facility, as does any change in what the business sells.
Over time, the UK manufacturing base has seen a continued slowdown, and the economy has become far more knowledge-based, technical, and service oriented. New growth sectors such as life sciences and technology provide huge opportunities for invoice finance lenders, but the services these businesses provide can be highly complex. A deep understanding of the terms of sale, potential areas of dispute and contractual safeguards allow lenders to fund growth in these sectors, as well as in the more traditional ones.
Knowing who the business is selling to – the purchaser – will always be a vital factor for the lender. There are several aspects to this. The first is centred on the credit quality of the purchaser – can they pay the invoice when it is due? This is less important if it is only a small part of the whole sales ledger, or if there is credit insurance. But if the purchaser represents a significant percentage of sales, non-payment would have a huge impact on the lender who had financed the sales, and consequently on the borrower’s ability to continue to trade.
Ideally, the risk of loss caused by non-payment by purchasers is mitigated by sales being spread between numerous different accounts, and strong credit management policies in place at the borrower. Sales to poor credit-risk purchasers, businesses associated to the borrower, or in export areas where debt collection is difficult, are generally avoided.
Assessing the financial performance of the borrower is a key aspect of approving any new invoice finance facility. Although the sales invoices themselves form the underlying collateral for the lending, a business with strong profitability and a solid net worth will be a more attractive proposition for the lender.
This provides confidence in the business and longevity in the relationship. And as there will be recourse to the borrower for any potential losses to the lender caused by unpaid invoices, it can also allow for flexibility in funding. This applies particularly if there are complications in the sales ledger, such as a heavy concentration to one purchaser, export sales or extended payment terms.
That said, start-ups, or businesses with cash pressure due to strong growth, can be equally attractive to a lender, particularly if they have strong management and debtors.
Robust internal systems at the borrowers are integral to a successful facility. Underpinning each sales invoice presented for financing, there should be a strong and auditable paper trail, from the purchase order through to the delivery of goods or completion of the services. With this “proof of debt” in place, disputes are more easily resolved, debt recovery more easily achieved and the prospect of fraud mitigated.
Accounting systems should also be strong, with regular management accounts and cash flow forecasts available to the business as well as the lender. These allow early discussions about future funding requirements.
Not every business looking for invoice finance will meet all five criteria at all times. Good management and a strong track record of financial performance will go a long way towards mitigating potential weaknesses in the purchaser base or complications with the goods or services provided.
Equally, a simple product and strong debtors can outweigh weaknesses in the balance sheet or poor internal controls.
But in the final analysis, it is the people that matter. The borrower will provide the lender with the necessary confidence that they are being accurately provided with all the information they need about the business to make sound decisions and that the borrower can be trusted to keep up with their repayments.
Aaron Hughes, Managing Director, Equiniti Riskfactor
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