Invoice-based financing solutions for SMEs
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Control of Cash!

The effects of the recent recession have shown us that “control of cash is the single most important factor in running any business however good the product potential and however good the skills of the management team” (Genghis Khan Guide to Business). We explore the use of invoice finance to firm up a company’s cash flow.


Stocks and debtors are the main source of the funding problem. On the debtor side for a company achieving sales of say £100,000 per month, after one month the company is owed £120,000 (i.e. including 20% VAT) equivalent to 10 per cent of annual turnover; after two months, £240,000 (20 per cent); after 3 months £360,000 (30 per cent); and so on.

Note how rapidly the debtor requirement climbs as ‘collection’ gets worse. You have to be very good at debt collection to achieve better than ‘two months’ – equivalent to around 20 per cent of annual turnover (which means goods are delivered in one month, getting paid by the end of the next). A company whose stated terms of trading are ‘30 days’ cannot even begin to press for collection until 30 days have elapsed. If it has to get tough and issue a warning letter after, say 45 days and put the matter into the hands of solicitors after day 60, it could easily take another one to two months to sue successfully and actually get paid (altogether equivalent to 4-5 months).

Most big companies have formalised, computer-based payment systems, with built-in time scales of their own. Miss a delivery date or fail to get an invoice into the system on time and a whole further month may elapse before the next processing cycle takes place. Some companies close off their monthly payment requisitions a few days before the end of each month, say on the 26th, so delivery has to take place and the paperwork be processed through the system well before then.

Stocks create a similar commitment. A manufacturing company carrying say six weeks use of raw material stock, four weeks of work in progress and four weeks finished goods stock, will need finance equivalent to around 20 per cent of annual turnover just to fund that stock commitment.

Given poor control, stocks can escalate out of hand just like debtors. A job may be defective and have to be reworked with new material. A supplier may tempt you with bulk purchases of raw material at substantially reduced prices. You buy, all in one go, what turns out to be six months, twelve months, perhaps several years usage (particularly if the product does not sell as well as intended). Normal stocks meanwhile have to be maintained in addition to carrying the excess.

Creditors can be used the other way. But there is a limit to the extent to which you can delay payment to your suppliers before they withhold deliveries of vital materials you require for production and even take you to court.

As a very rough rule of thumb, you are beginning to strain your creditors harmfully once the total amount you owe (including trade creditors and VAT, PAYE, etc) goes materially over about 13 per cent of annual turnover.

Of course, the cash need increases in direct proportion to the build-up of turnover. A company running at £1,000,000 pa turnover needs around £270,000 to fund net current assets (stocks + debtors – creditors). At £2,000,000 pa turnover it needs £540,000. At £10m pa it needs £2.7m. At £100m £27m.

This feature is the biggest single cause of company failure – through management not being fully aware of the issues and, failing therefore to cater for them adequately in advance.

The above figures are typical for a manufacturing company. Service and distribution companies can, indeed must, operate at much lower levels (a reflection of the much lower gross margins typical of such companies). As a very rough rule of thumb, the net current asset requirement expressed as a percentage of annual turnover should not be allowed to exceed the gross margin percentage.

Allow control to slip – so that instead of pegging stocks and debtors, each to 20 per cent – they become say 25, 30 or 40 per cent – and again the total requirement escalates frighteningly.

How can the overall net current asset need be met? The obvious first port of call is the bank, for overdraft facilities. However, you are fortunate if a bank is prepared to provide the full amount required.

A bank must have regard for security and ask itself “What could the assets be sold for in the event of a failure?” Most of the debtors could probably be collected (apart for a bad or doubtful debt element). But what about the stock? Work in progress is no good until it has been turned into finished product. Finished product itself is of no value unless it can be sold. If the company cannot sell it, i.e. in the event of failure, what hope is there for someone like the liquidator succeeding in doing so?

In addition, overall the bank will have regard to ‘gearing’, the relationship between total borrowings (including hire purchase, etc) and the net worth of the company (share capital plus retained profits/minus retained losses, as the case may be). In the formative years a bank may wish to peg total borrowings somewhat short of net worth (because of the continuing erosion of net worth by losses). Later, once a steady stream of profits begins to emerge, the bank may take a more optimistic view.

So, borrowing ability, overall depends on the present state of the company and its immediate prospects, in addition to the specific stock and debtor security available. If the bank won’t go to the full extent required, other sources of funding must be sought.

A very good potential source is factoring or invoice discounting. Here it is usual (but not always) for the factor to take over administration of the sales ledger (for a fee of between 0.20% and 1.50% of turnover, depending on turnover size, quality, spread of debtors and general workload) and also undertake actual debt collection. The factor will advance typically 70-85% of invoice value within a day or two of despatch of the goods, charging interest rates comparable with bank interest, until the debt is collected, whereupon the 30-15 per cent balance is remitted to the company.

In most cases the factor will only advance against debts to ‘approved’ customers. The factor will conduct their own independent credit check and only ‘approve’ customers whom they consider satisfactory (which is the usual safeguard).

Factoring and invoice discounting used to be regarded as a type of ‘rescue’ finance; the last port of call before liquidation. Fortunately, those days have long since passed (perhaps brought about by a better, general understanding of cash flow issues, along the lines mentioned earlier).

It is now regarded as ‘mainstream’, and a very valuable source of funding, particularly for the rapidly growing company. Debtors are being financed direct, at whatever level, and there are fewer ‘over gearing’ considerations. In addition (in the case of factoring) the company is spared the physical task of sales ledger operation, debt collection and credit checking.

However, factoring does, of course, remove the debtor element in the security available to the bank for conventional overdraft purposes. Conventional bank facilities will accordingly be scaled back but usually not by nearly as much pro-rata. Bank facilities plus factoring usually provides much more than factoring alone, particularly in rapid growth situations where the bank facility becomes ‘gearing’ limited whereas the factoring does not. Factoring can also act in export markets.

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