Business finance: Invoice or asset-based funding?

Start-up business
Anthony Harrington By Anthony Harrington, CA magazine

22 June 2016

Businesses aiming to maintain cash flow in a post-crash world can seek alternatives to traditional finance, reports Anthony Harrington.

The fates seem to have conspired in recent years to alert businesses across all industry sectors to the need to look for alternative sources of finance. 

The global financial crisis of 2008 created huge liquidity problems. That by itself would have been enough to create some issues between many companies and their primary banks. 

On top of this, we have the Basel III Regulations for banks, which are designed to see that banks do not ‘over-leverage’ themselves, but which, as a side effect, make it more expensive for banks to lend to ‘riskier’ clients.

Unfortunately, in Basel III terms, small and medium-sized enterprises (SMEs) are deemed to be higher risk, so banks have to set aside more reserve capital as a counterweight in proportion to the scale of the loans they make to them. Basel III, in other words, disproportionately affects SMEs which, taken globally, account for about half of the world’s GDP. So alternative funding is not just a “nice to have”, optional extra – it is essential if the UK and the global economy are ever to emerge from the current “slow-to-no-growth” era.

Invoice and asset-based finance

The two main alternative sources of funding for the working capital requirements of SMEs are invoice finance and asset finance, known collectively as asset-based lending (ABL). Either or both can also be a complement as well as an alternative to traditional funding provided by conventional overdrafts and term loans.

Invoice finance and asset finance are often used in tandem with each other and can be very complementary products, although each is distinct from the other. Asset finance is chiefly about investing in your company without compromising working capital, whereas invoice finance goes directly to working capital by turning products and services into cash received, and doing so as soon as the invoice is raised and approved.

There is clear evidence that a growing majority of businesses of all sizes now see asset finance as the right type of financing for acquiring assets with a defined life cycle.

Asset finance has a long history and is growing strongly. Ian Wood, head of marketing with Lombard, points out that the company does a half-yearly survey of its asset finance customer base. That survey shows that over the last 18 months there has been a significant increase in demand for this type of product.

“There is clear evidence that a growing majority of businesses of all sizes now see asset finance as the right type of financing for acquiring assets with a defined life cycle,” he notes.

Ian points out that statistics from the Financing and Leasing Association show that new business written by the asset-based lending sector increased by 9 per cent year-on-year, in comparison with the figures for February 2015, while the 12 months to April 2016 are up 11 per cent year-on-year, with some £29.3bn of ABL loans made.

“If you look at the statistics for overall lending, then clearly traditional term loans remain the most popular source of finance, followed by overdrafts, but asset-based lending comes up a very good third,” Ian comments.

The case for invoice finance

For many businesses, the stigma that used to be attached to factoring and invoice finance has now virtually vanished and raising cash on the sales ledger is today seen as a standard and solid route to raising working capital. Providers suggest that some work remains to be done, however, in clarifying for SMEs what invoice finance can do for them, and in informing their advisers.

One of the things that has driven greater acceptance of alternative funding models has been the experience of mainstream banks withdrawing funding to many business customers during the crash of 2008 and in the years that followed. As a result, companies right across the country are more willing to look at different funding sources.

Ian adds that many business owners across a range of sectors have learned the hard way that overdrafts can be withdrawn and lending can be restructured if a bank starts to have any concerns about the business’s ability to support the overdraft or loan. With invoice finance, the business gets a level of financing that is linear to its trading capacity. If it starts selling more to its clients, its invoicing goes up and it can finance further sales because it is getting around 85 per cent to 90 per cent of the value of the invoice paid instantly into its account.

Invoice finance is not sector-specific, but it works best for those businesses that have a stable, and relatively well-tested, base of business customers who are account holders with the company and are relatively reliable payers.

Nick Lander CA, chief operating officer of the investment firm Volvere plc, says he finds both asset finance and invoice finance to be very interesting options in some of the companies in which Volvere invests.

“One of our companies that uses invoice discounting is a provider of consulting services to the automotive sector, while the other is a food manufacturer. They couldn’t be more different, but they both find invoice discounting very useful,” he notes.

The point Nick makes about the difference between the two companies is important because it shows just how flexible invoice finance is as an option. The food manufacturer dispatches boxes of product to customers who receipt delivery and the transaction is complete. When the consultancy issues an invoice it may be for a service that’s still being provided and there can be the possibility that the client will turn around and dispute the invoice on the grounds that it is not satisfied with the work being done.

“Invoice discounters have a very different approach to these two kinds of operation,” says Nick. “They are very happy with the box-shifting kind of business because there is no arguing with a receipted delivery, assuming the product is to standard. If there is a standing order to buy and the client is drawing off product against a contracted order, the invoice discounter knows exactly where it stands. So even in the event of insolvency, the invoice discounter is likely to get paid. With the consultancy, there is a greater need to understand the business and ensure the risk of non-payment is mitigated.”

Yet despite the theoretical difficulty attached to qualitative deliverables, the invoice discounter’s due diligence process showed that the consultancy had a good record of receiving undisputed payments from its clients.

“We did a beauty parade of potential invoice discounters for both businesses and we ended up staying with Lloyds for both. They were competitive as far as rates were concerned too,” Nick comments.

The benefits of asset finance

As Colin Walls, head of trade and working capital at Bank of Scotland, notes, one of the additional benefits of opting for asset financing to purchase an asset is that the lender can often come up with a better price for the borrower than they would get if they were to use traditional hire purchase to buy the asset. This is because a lender can often take a view on the residual value that will remain when the contract ends.

“Taking residual-value risk is an accepted feature in the asset-financing industry in leasing arrangements. It often means that the borrower gets a better price because they are not being asked to fully amortise the product,” he adds.

Two further great strengths of asset finance are that it removes the need to fund a new asset purchase upfront and can be structured so that payments are spread over the anticipated useful life of the asset. This last point means companies do not have to allocate great chunks of working capital upfront when they want to acquire new equipment, for example, in order to increase production.

The array of possible assets that could be deemed suitable for asset finance is too extensive to list, ranging as it does from computer equipment to plant and machinery and on up to “large ticket” items such as aircraft and ships. As Colin notes: “A number of different criteria will be considered by a lessor before entering into a finance agreement. This will include the type of asset, whether it is new or used, where it will be located and the nature of the use to which it will be put. All of this has a bearing on how we reach a view of its potential useful economic life.”

'Restructuring and rescuing'

Both forms of finance are also very useful sources of funding when a business is undergoing restructuring or rescuing. Colin points out that invoice finance will help a cash-strapped business by unlocking the value tied up in outstanding invoices. Putting an asset-finance contract in place alongside invoice finance, perhaps through a sale-and-lease-back mechanism, helps to unlock the value tied up in plant and machinery, and other assets.

Grant Lockhart-White CA is head of group finance at Anglia Farmers and sits on the ICAS Business Policy Committee and on its SME group. He points out that some 70 per cent of businesses in the UK are self-funding.

“Invoice finance is not particularly useful if you have a large number of customers with very low billing. I was in a company some years ago, a food producer, where we supplied around £1m a week to the major supermarkets. That kind of company is ideal for the big invoice-finance operations to take on as a client,” he says.

These forms of finance should form an indispensable part of a business’s toolkit, but many SMEs aren’t aware of these options. Looking at ways to unlock the value tied up in their assets will better place them to deal with these pressures.

One of the drawbacks he experienced was that there could be unpredictable charges made by supermarkets which greatly lowered the value of an expected invoice, and caused the invoice discounter to claw back funds – always an annoyance for an SME, he says. These charges could be for something such as transport.

“You might suddenly get a £120,000 transport bill from the supermarket. You knew it was coming at some time, but you did not expect it to be taken off this particular invoice, and you have already drawn down the money from the provider – that kind of thing can be painful,” Grant notes.

Another point is that, in his experience, there can be costs from the invoice discounter that need to be kept in mind.

“We were audited once a quarter, which generated a £2,000 bill, and there was the disruption of having auditors on site to consider. Plus, the discounter decided at one point to step up the audits to monthly – which added more cost and disruption. So companies need to be clear that they are really going to benefit from going into this. Once you are in invoice finance, it can be very difficult to leave because of the impact on your cash flow,” he says.

Opportunities for businesses

Steve Everett, head of product and proposition for Lloyds Bank Global Transaction Banking, says that fresh challenges for SMEs’ cash flow, such as the introduction of the National Living Wage earlier this year, can only encourage the take-up of asset-based lending. The fact that customers are, on average, taking longer to pay invoices also puts pressure on working capital.

He says: “Invoice finance can provide the sure footing to get through the tough weeks ahead. It enables enterprises to unlock cash flow tied up in delayed payments by providing access to up to 90 per cent of the value of issued invoices, all within 24 hours ... and asset-based finance can convert the value tied up in stock, plant, machinery or property into the cash needed to face new challenges and position a business for growth.”

Lloyds’ Business in Britain survey revealed that the average SME has more than £600,000 in physical assets, usually owning more than three-quarters of those assets outright.

Steve concludes: “These forms of finance should form an indispensable part of a business’s toolkit, but many SMEs aren’t aware of these options. Businesses are currently facing a number of new headwinds, all of which will affect their working capital. Looking at ways to unlock the value tied up in their assets will better place them to deal with these pressures.”

As with all forms of business finance, it pays to read and understand the small print, but for the right business, and the right circumstances, invoice and asset finance can be important options for a company aiming to grow.

The full version of this article appears in the June 2016 issue of CA magazine.

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