When a new business is formed, the founders will, by definition, be of a sales driven, entrepreneurial nature. While these skills are fundamental (let’s face it if a business cannot generate sufficient sales activity then it will not get off the ground!), the area of working capital finance and cash flow management are often neglected.
The resulting statistics should be taken on board by all SME directors and owners:
- 60% of businesses fail as result of cash flow issues.
- Most businesses wait in excess of 60 days for their customers to pay outstanding accounts and credit management amongst SMEs is often re-active rather than pro-active.
It is clear that if businesses have to wait 60 days for their customers to pay outstanding invoices, they will need some financial support in order to ensure that they can pay their own suppliers on time and meet other day-to-day expenses whilst they wait for payment.
For many years the first port of call for this working capital finance has been the high street bank and an overdraft has been seen by many as the solution to the problem. While this has worked quite well for many businesses, certain issues are important when considering an overdraft;
- An overdraft is an ‘on demand’ facility, which means the bank have the right to recall their money at any time.
- There can be conditions, or covenants as banks call them, revolving around the net worth and profitability of the business.
- Banks often require tangible third party security to support overdrafts, frequently in the form of a second charge on the business owner’s residential property.
For these reasons, banks are often criticised for the conditions imposed when they lend money. Remember, banks do not see themselves as risk takers, more as risk managers and they clearly must protect not only their shareholders’ investments but also their customers’ deposits.
The resulting, sometimes inflexible approach to lending means that the use of overdrafts for business finance is declining. If a business plans to use an overdraft, it should consider the terms carefully and the implications of giving third party security to support the overdraft.
An increasingly popular way of financing working capital is by way of a factoring arrangement.
Factoring originated in the USA and was the prime source of finance for the textile trade on the East Coast of America in the early part of the 20th Century. In America the overdraft no longer exists and each segment of a business; debtors, stock, plant and machinery are separately funded. It is inevitable that this practice will become the norm in the UK within the next few years.
As regards the mechanics of factoring, such facilities enable a business to draw an initial advance from the factoring company representing a fixed percentage of the value of outstanding invoices. The customer then pays the factoring company for the outstanding invoices and the factoring company, after deduction of its fees, sends the balance of the value of the invoices to the client.
In America the overdraft no longer exists and each segment of a business; debtors, stock, plant and machinery are separately funded. It is inevitable that this practice will become the norm in the UK within the next few years.
The factoring company will also assist in the orderly collection of the invoices; highly experienced credit controllers are assigned to each client, often speeding up collection times and probably providing a service superior to that which many companies aspire to.
One of the strengths of the factoring industry is the number of companies in the sector, currently in excess of 65, ranging from large, bank owned factors to small, independent and often privately owned companies. All share an enthusiasm to ‘do business’ and with their ability to look at the wide range of situations presented to them, there is a home for virtually every scenario that you can think of.
In summary the strengths of a factoring facility are as follows;
- A committed facility- usually 12 months but can be longer.
- The funding is geared to the sales of the business – not the net worth or profitability, which makes factoring an ideal choice for new start companies. Factoring companies are more concerned with the quality and spread of the customer base than the overall balance sheet strength.
- Personal security is rarely sought by factors (those providing the factoring service) in support of business funding.
- There is a far greater choice of providers within the factoring industry than within traditional banking and it is often beneficial not to have ‘all your eggs in one basket’; factoring will work alongside your existing bank account.
And a few words of advice…
Unless a business has got sound procedures regarding the production of invoices and vetting of customers it will not gain the maximum benefit from a factoring facility regardless of the factor offering the facility.
Here are some simple rules:-
- Be a good supplier – if your product or service is of a good standard your customers will want to continue to do business with you. Think of your own valued suppliers; you want to ensure continuity of supply, so you pay them promptly.
- Most customers pay their invoices in an orderly manner, so that if your invoice accurately records the goods or services provided, it will be among the first to be authorised and paid. If inaccurate, it will go to the bottom of the pile.
- Check the trading styles of your customers. Are they limited companies, sole traders or partnerships? Check them out and set credit limits. Remember today’s customer could be tomorrow’s defendant in court who is trying to avoid paying you, so it is important that businesses know who precisely they are dealing with.
- Set out your terms of trade so that your customers are fully aware of when they have to pay and what happens if they do not pay.
- Issue invoices as soon as possible and make sure they are correct in every way. The sooner your customer receives the invoice the sooner it will be processed.
- Ensure you have supporting documentation where appropriate and always use customer references where provided.
- Be pro-active in your credit control procedures. Do not leave the chasing of money until you are desperate for payment. Your customer would rather have regular reminders rather than panic phone calls to help get you out of a problem.
While much of the above is in your hands, the right factoring company will guide you in all these areas while allowing you to grow your business. Think about it…