Is your business, like many others, battling with cash flow? Invoice discounting may save your business, by taking off the cash flow pressure and giving you some breathing space.
Most new businesses fail within the first few years and this is often due to a lack of working capital and pressure on cash flows. Invoice discounting is a simple way to obtain working capital for your business. It is flexible because you decide what your working capital requirement will be at any given time. Any business which regularly supplies goods or services on credit to a large company with a good credit standing, can use invoice discounting.
The mechanism is simple: the business sells its rights to future invoice payments to a finance house. The finance house pays the business owner immediately, takes over the invoice and collects the money from the debtor when the invoice is due for payment. The difference between the invoice amount and the amount paid to the business owner is the discount, i.e. the fee charged by the finance house.
CapX Finance provides both disclosed and undisclosed (confidential) invoice discounting to SMEs.
Invoice discounting is the ideal way to raise finance for a smaller business which has a few larger debtors.
The financier buys the outstanding invoices at a discount, pays the client immediately and collects payment from the debtors when the invoices are due.
Invoice discounting has the same cash flow effect for the small business as granting a cash settlement discount to its clients.
Invoice discounting in South Africa has been around for many years. It is offered by a small number of specialist financiers. Each financier’s product offering differs from the others. Some are more suitable for small businesses and some for larger businesses. Some financiers prefer certain industries.
Invoice discounting is ideal for small businesses with large debtors. The large debtors usually demand very generous credit terms from its small suppliers. This leads to cash flow problems for small businesses.
Provided that the large debtors are creditworthy, they can be used to raise finance for the small business by discounting (selling) the invoices issued to the large debtors.
The most important advantages of invoice discounting are that it can be implemented quickly and that it can sometimes be the only way for a smaller business to raise finance.
A business’s debtors book is an important asset on its balance sheet which is usually funded by its own capital.
When it runs out of working capital, the small business will experience major cash flow problems and may even be liquidated. Invoice discounting can save a small business from disaster.
Invoice discounting is a more expensive way of raising finance than commercial bank funding, but it may often be the only solution. Invoice discounting should therefore be considered when normal bank funding cannot be obtained.
From a cost perspective, it is comparable to granting a cash settlement discount to debtors.
Susan’s Sweets produces and supplies candy floss to a large retailer, PicFoods. Susan’s Sweets has to pay cash for all supplies needed to make the candy floss, but PicFoods demands credit terms of 30 days after statement.
As the sales of candy floss grow, the amount outstanding from PicFoods also grows. Susan’s Sweets does not have enough working capital to pay cash to its own suppliers anymore.
By discounting its PicFoods invoices to a financier, Susan’s Sweets can raise cash to pay for its supplies. It may even negotiate cash discounts from its suppliers.
Generally speaking, invoice discounting refers to raising finance against a few larger debtors.
Factoring refers to raising finance against the whole debtors book, usually consisting of many smaller debtors.
However, the terms are often used interchangeably. They may also have different meanings in different countries.
Disclosed invoice discounting refers to the debtor being aware that its supplier has discounted its invoice to a financier.
The supplier, debtor and financier work together, so that the debtor’s good credit standing can be used to raise funding for its supplier.
Typically the debtor would verify the validity of the invoice to the financier and would also pay the invoice amount directly to the financier on the due date.
Disclosed invoice discounting is ideal for a smaller business with a few large debtors but lacking an established track record itself. It is therefore ideal for start-up which has been in business for a few months.
Confidential invoice discounting (also called “undisclosed invoice discounting”) refers to a financing transaction where the debtor is unaware that its supplier has discounted the invoice to a financier.
The debtor does not verify the validity of the invoice and also does not pay the invoice amount to the financier, but directly to the supplier.
The financier therefore relies on the supplier to pay the financier when the invoice payment is received. This implies that the financier takes credit risk on the supplier as well as the debtor.
Confidential invoice discounting is suitable for a business with a good track record and solid financial statements but which does not qualify for bank funding.
The product or service must have been delivered or rendered already;
The debtor must be satisfied with the product or service;
The debtor must have a good credit standing; and
The invoice must have been issued.
Debtor finance is a very wide term and describes a way of raising business finance by using the business’s debtors as security for the financier. It has the same meaning as “invoice finance”.
There are many different methods of debtor finance, such as invoice discounting and factoring, which each also have a variety of sub-categories.
Debtor finance is offered by several specialist financiers and banks in South Africa. It has been around for many years and is a recognised international finance product with many different sub-categories.
Typically, each financier specialises in one or more different types of debtor finance.
Some of the financiers also focus on specific industries, such as mining, manufacturing, transport, construction, retailing etc.
The major benefit of debtor finance is that an asset on the balance sheet which is sometimes overlooked, i.e. the debtors, can be used to raise finance.
This is especially true if banks are not interested in funding the business because they see it as “too risky”. It is a quick and simple method of raising finance when bank facilities are not available or fully utilised.
Debtor finance rates typically vary between about 3% and 7% per month.
In some cases the monthly costs could be lower, but the financier may then charge a collection cost (say 2% of all outstanding debtors) which should also be taken into account when comparing costs.
Sometimes the costs are fixed for a month, e.g. the cost would be 5% irrespective of the actual time it takes before the debtor pays.
In some cases the costs are calculated on the full amount of the invoice and in other cases the costs are calculated only on the portion which is actually advanced to the client.
Sometimes a minimum monthly fee is charged even if no debtors are discounted during that month.
Small businesses which are considering debtor finance should ensure that they understand exactly how and when fees are charged and calculated so that they make an informed decision when comparing different financiers and products with each other.