Despite the government’s ‘credit easing’ efforts of late the volume of new lending continues to fall (see page 4). The banks say that it’s lack of demand that’s driving this trend but even business owners who’ve successfully applied for loans are saying the process is difficult.
This difficulty is prompting many business owners to look elsewhere for finance and one of the most popular options is invoice finance. This is where a company borrows from a finance company using its outstanding invoices as collateral. You borrow some of the money you’re owed now and get the rest when your customers pay. The invoice finance company takes a fee made up of interest and admin charges.
This is an attractive option for small and start up businesses because it eases cash flow worries that come up when customers are paying on 60 or 90 day terms. These kinds of businesses are usually operating at a loss for the first few years or with very slim margins so protecting cash flow and working capital is of paramount importance.
But how does this form of borrowing stack up against traditional bank lending – both in the form of loans and business overdrafts? Let’s find out…
Getting a loan from the bank is the most traditional form of business financing and also usually the cheapest. Interest rates for small business bank loans are typically around 5% for a secured loan or aroud 12% for an unsecured loan.
Of course, if you get a loan secured against your assets (which in the case of small business owners can often include personal property) then those assets are at risk if you don;t keep up repayments.
In addition, a loan is the most inflexible of the financing options reviewed here: you have to carefully calculate how much money you’ll need to borrow for the length of the loan term, pay interest on all of it and face repayment penalties if you want to pay it back early.
Pros: Cheap (in the case of secured loans); Cons: Inflexible; Puts your assets at risk (in the case of secured loans); Difficult to obtain
Overdrafts with your business banker usually have to be arranged in advance, otherwise you could face penalty charges which equate a whopping 30% e.a.r. Even if you do formally arrange an overdraft you’ll still likely be charged at least 3% over the Bank of England base rate for the money you borrow and a one-off fee of about 1.5% of the agreed overdraft limit.
While this form of finance is flexible – you only borrow what you need – it can be expensive and lull you into a false sense of security. If you don’t carefully manage your overdraft facility and end up exceeding your limits you’ll be exposed to very hefty charges.
Pros: Flexible; You only borrow what you need; Cons: Needs careful management; Difficult to obtain (though not as difficult as bank loans); Expensive; Restricted borrowing
The last of our readily available finance options for small business is also the least understood. This might be due to the variety of names it goes by. These include invoice discounting, invoice factoring, debt factoring and sales ledger financing.
These are all essentially different names for two distinct products: invoice discounting and invoice factoring.
An invoice factor will lend you money against your outstanding invoices on the condition that they take over the process by which you raise invoices and collect payment. This can be helpful for small businesses which lack the manpower for proper credit control but can also leave some business owners feeling like they’ve given up too much.
You can normally draw down up to 90% of the face value of your invoices, on which you’ll pay 1.5 to 3% over the base rate. You’ll also pay fees of 0.75% to 2.5% of your turnover.
Invoice discounting on the other hand lets you retain your credit control processes and keep the arrangement confidential. It’s also cheaper due to the lower amount of labour involved.
You’ll be able to draw down slightly less of the value of your invoices but will pay only 0.2% to 0.5% of your turnover as a fee.
Fees for both options tend to reduce as your business grows and becomes less of a perceived credit risk.
There is also one other vital aspect of invoice factoring you may wich to consider: credit protection. Under a normal agreement, if your customers fail to pay the finance company will expect you to make up the shortfall. By paying another 0.5% to 2% of turnover you can have the invoice financ ecompany absorb this risk. This is also known as non-recourse factoring/discounting.
Pros: Flexible and sustainable (you only borrow what you have coming in, the amount you can borrow grows with your business); You can outsource credit control; Cons: More expensive than bank loans
The form of financing most appropriate for your business will depend heavily on your particular circumstances, including the availability of bank finance and the cost to your company. It’s a decision that shouldn’t be rushed – get out the calculator, warm up the spreadsheets and really crunch those numbers. Work out your best possible estimates of the volume of business you’ll be doing and the amount you’ll need to keep your creditors satisfied and your expansion plans on the boil.
If you’re unsure then take independent advice: never rush into a decision about finance that could jeapordise your business.