The five principles of invoice financing
The great business empires of the Phoenicians, Romans and Elizabethan England are all said to have used some form of invoice factoring to finance their expansion. For thousands of years, there have been bankers willing to give loans against unpaid sales invoices.
Bill financing is now the preferred method of business credit, moving beyond bank overdrafts to SMEs and suitable for a growing number of businesses in the service economy where debtors are often the only significant assets. It is considered the optimal way to finance the growth of the business because the loans are directly tied and secured by the sales ledger of their customers.
However, while the way we do business in the 21st century may have changed, the guiding principles that lenders use to decide how much to lend, to which companies, and for what return, remain largely unchanged.
Technology has brought a bit of science to financial analysis, but the lender should always be asking the same questions, because the five principles behind a successful fundraising relationship are as true today as they were. centuries ago.
Below, I examine these values ââand show how they guide the lender and borrower in understanding the roles and responsibilities of each party within an invoice financing partnership.
At the heart of every business are its employees. Understanding who they are, their motivations, their experience and their background is essential, and it goes well beyond the usual âKnow your Customerâ (KYC) and anti-money laundering checks.
Essentially, it comes down to how senior management runs the business and whether it can be trusted.
There should be a relationship of mutual trust and respect between the lender and management, and the confidence that the client can be trusted to provide accurate information about their business. A history of success, a respected status in the community, and an âopen bookâ approach to due diligence can be more valuable than any amount of personal compensation from less trusted directors.
Understanding what the business does – its products or services – is fundamental. The success of an invoice loan requires an appreciation of what could lead to it not being paid on time, if at all. Analyzing historical credit scores or bad debts will give an indication of the levels of unpaid invoices, and the simpler the business, the lower those levels tend to be. Litigation and uncollected invoices should be monitored throughout the life of the facility, as should any change in what the business sells.
Over time, the UK manufacturing base has experienced a continuous downturn and the economy has become much more knowledge, technical and service oriented. New growth sectors such as life sciences and technology present huge opportunities for invoice finance lenders, but the services provided by these companies can be very complex. A thorough understanding of terms of sale, areas of potential litigation, and contractual guarantees enables lenders to finance growth in these sectors, as well as more traditional ones.
Knowing who the business is selling to – the buyer – will always be a vital factor for the lender. There are several aspects to this. The first focuses on the buyer’s credit quality: can he pay the bill when due? This is less important if it is only a small part of the entire sales book or if there is credit insurance. But if the buyer represents a significant percentage of the sales, the non-payment would have a huge impact on the lender who financed the sales, and therefore on the borrower’s ability to continue trading.
Ideally, the risk of loss caused by non-payment by buyers is mitigated by distributing sales among many different accounts and by having strong credit management policies in place with the borrower. Sales to poor credit risk buyers, to companies associated with the borrower, or to export areas where debt collection is difficult, are generally avoided.
Evaluating the borrower’s financial performance is a key aspect of approving any new invoice finance facility. While the sales invoices themselves are the underlying collateral for the loan, a business with high profitability and strong equity will be a more attractive proposition for the lender.
This gives confidence in the business and the longevity of the relationship. And since there will be recourse to the borrower for any potential loss to the lender caused by unpaid bills, this can also allow funding flexibility. This especially applies if there are complications in the sales book, such as a heavy focus on a buyer, export sales, or extended payment terms.
That said, start-ups or businesses with cash flow pressure from strong growth can be just as attractive to a lender, especially if they have strong management and debtors.
Robust internal systems at borrowers are integral to a successful installation. At the base of every sales invoice presented for financing, there must be a solid and verifiable paper trail, from the purchase order to the delivery of the goods or the completion of the services. With this âproof of debtâ in place, disputes are more easily resolved, debt collection more easily accomplished, and the prospect of fraud lessened.
Accounting systems should also be strong, with regular management accounts and free cash flow forecasts for the business as well as the lender. These allow for early discussions on future funding needs.
Not all businesses looking for invoice financing will always meet all five criteria. Good management and a solid track record of financial performance will go a long way in alleviating potential weaknesses in the buyer base or complications with the goods or services provided.
Likewise, a simple product and strong debtors can offset weaknesses in the balance sheet or poor internal controls.
But at the end of the day, it’s the people that matter. The borrower will provide the lender with the necessary reassurance that they are accurately receiving all the information they need about the business to make informed decisions and that the borrower can be trusted to meet their repayments. .
Aaron Hughes, Managing Director, Equiniti risk factor
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