Why you need to look beyond Invoice Discounting headline rates to get the full story!

With so much macro turbulence impacting the cost of doing business across Europe today, it’s not surprising that more and more companies are reviewing their cashflow and working capital requirements. Longer payment terms, increasing prices and raw material shortages are all having an unprecedented impact on the day to day cashflow of businesses.

The turbulence we are seeing now on a disturbingly regular basis means that even the best performing companies can fail due to not having access to a reliable source of ongoing funding support – one that they can activate quickly to allow them to react to sudden change.

When you add in the imminent departure of Ulster Bank, it is no surprise to see so many companies on the lookout for an Invoice Discount facility to help manage cashflow more efficiently.

So, what should you be looking out for if you’ve decided to consider Invoice Discounting for your business? In this article we will bring you through the full list of headline and additional costs to look out for, and, outline the restrictions that will be applied that will have a huge impact not only on how much you pay, but how much funding will be released to you.

The first step? Compare the market

As with any strategically important decision, the first step is to research the market and see what options are available. Instinctively, business leaders will most likely approach a small number of traditional lenders like pillar banks for a quote. The first thing they will be sold on is the headline rate that the lender will offer. This will definitely look extremely attractive. But it would be a mistake to base any decision on the headline rate.

Firstly, there will definitely be a pretty long list of additional costs that will apply, which bring up the ‘True Cost’ of funding to a rate much higher than you thought at the outset.

The market has many new, more innovative providers who will be just as cost effective when all things are considered, not just the headline rates!

In fact by the time you read this article you may discover that the headline rate is not the most important consideration when selecting an Invoice Discounting partner.

Possibly more important than the headline rate offered is the quantum of funding that the provider will advance you. Not a whole lot of good negotiating a ‘better rate’ if the actual amount of funding they are prepared to give you will not meet your business needs.

A quick definition of Invoice Discounting

For clarity, invoice discounting is a form of short-term funding where companies can access upfront funds secured against the value of the outstanding invoices on their sales ledger on an ongoing basis. Essentially it creates a line of credit by releasing  the value of an agreed percentage – usually around 70-80% – of the invoices value as soon as the invoices are raised.

As invoices are paid, this credit amount is automatically repaid, allowing for redrawing against new invoices created and awaiting payment.

So, It acts as a revolving line of credit that is closely aligned to a business’ expected income.

What type of companies is it appropriate for?

There is a common misconception that invoice discounting is a form of finance used by distressed or under-performing companies. This couldn’t be further from the truth. In fact, the Credit & Risk Departments in most invoice discount providers are likely to reject any struggling companies based on their profiling and risk analysis!

The companies that invoice discounting works really well for is those that:

• Have high quality debtors but are subject to long payment terms or frequent late payments that make predicting working capital levels difficult
• Have to make a large or unplanned purchase. For example this could be buying a new piece equipment or higher levels of stock to meet the demand of increased sales. Invoice Discounting can release the required capital without having to resort to a longer term loan obligation.
• Want to capitalise on an early payment discount from suppliers
• Need to speed up the cash cycle without having to discount the price of their goods for early payment.
• Need to fund an expansion
• Have a large one-off payment to make. For example a tax or rent payment, it allows companies to pay these without putting undue pressure on day-to-day cashflow.

Crucially, many of these requirements can be short term in nature, therefore not particularly appetising to traditional funders, who will typically look for a more protracted legal process, longer repayment terms, security against the sums advanced and, most likely, a personal guarantee from the Directors of the company.

The amount of funding that Invoice Discount Providers will extend to companies varies, depending on risk profile, quality of the debtors, geographical location, repayment terms and a myriad of other factors.

To truly compare the invoice discount providers, you need to factor in a long list of potential additional costs that are not necessarily made clear to you at the outset!

So, like going shopping to prepare a special meal, you need to make sure you have a shopping list of all the ingredient costs!

The Headline Costs

When a Funder presents a company with the terms of an invoice discounting facility, the offer will typically point to some key costs to be charged and refer to other fees that may be applicable. In fact they will most likely draw your attention to these costs and encourage you to compare them versus anyone else in the market to prove how competitive they are.

The main costs that are shown to Companies by traditional providers are:

The Cost of Funds Rate

This is an annualised percentage rate that is being charged on the amount of funds that are advanced through the year. The discount rate is typically shown as a % margin on top of a globally recognised base rate e.g., 4% margin plus 3-month Euribor.

This is the headline cost that a Company CFO would normally focus on and might well make their decision based on this alone when choosing a provider.

Typically this will be shown to be as attractive as possible and a traditional provider would showcase this as being quite competitive – typically equalling or slightly eclipsing the cost of providing the funds being offered.

The Arrangement Fee

This is a flat fee normally charged on a one-off basis, or once a year, and is viewed as a fee chargeable for putting the facility in place, completing the legal paperwork and the onboarding process required to provide the Company with the funding. This can vary depending on the facility size and amount of work required but typically ranges between €2,500-€10,000.

Some might disregard this cost from the overall cost comparison, however in reality this is a cost on the funding received and should be added to the calculation of the overall cost to the facility, and apportioned over the term of the facility.

The Administration Charge

This is a fee typically charged monthly, either set out as a flat fee or is calculated by a % of the facility advanced and subject to a minimum annual charge.

It covers all the ongoing day-to-day costs associated with managing a facility for the Company by the traditional provider. This fee should be factored into the overall cost of funds calculation.

The Audit Fees

A typical condition of traditional Invoice Discounting providers is to charge an annual audit fee for work undertaken to either visit or via desk research to review and audit the Company in question. This might involve reconciling certain balances to published or provided management accounts, sampling of certain invoices to related evidence documentation and financial statement analysis.

Costs here can be as much as €500 per day per audit.

Extra, extra don’t read all about it!

While it might be unfair to label all the possible extra fees that many providers apply as ‘hidden’ – many of them are buried deep in the final Term Sheet or not revealed at all, so it pays to be diligent and eagle eyed when reviewing the proposal and certainly way before any legal commitment is entered into!

Importantly, the impact on the final cost of finance can be very dramatic, so as our legal friends might say, buyer beware! It is up to you as the buyer to understand the costs you are signing up for!

Collection Fees

Remarkably, on top of the Monthly Admin charge, many will charge a further fee for the privilege of collecting customers money! This could be a seemingly innocuous 0.1% charge, however as it is charged every time each of your customers make a payment, it could end up being quite a large cumulative cost on a monthly/annual basis.

Trust Account Fees

Most providers of Invoice Discounting facilities would require a Company to have their customers pay into a segregated Trust Account – some charge an additional fee to set it up!

Transfer Fees – normal and same day

You’d expect the administration of transferring fees would be covered in the monthly fee – once again you could be wrong. Many traditional providers charge for each and every transfer of funds made. For those who do, €30 per transfer would not be unusual and this would typically take them 2-3 days to be executed from request! Naturally they will offer same day transfer and yes, you’ve guessed it, same day transfers are charged at a higher cost per transfer, typically around €50 per transfer. Again, on the face of it a small fee but these can really mount up over the course of a year.

Another important clarification to seek is that should you close the facility and change to a different provider will they charge for ‘re-direction of funds’ sent to a new provider, while debtors re-direct your funds. Many do!

Clearing Days Interest

This is one of the most covert costs of a facility with some Invoice Discounting providers. When funds are received by the provider from customers of the Company, they will not apply the funds off the open balance for 2-3 working days. This means the Company is paying interest on a higher value than if the settlements were applied straight away.

Refactoring Charge

This is a fee charged when unpaid invoices have gone over an agreed period set out in the contract, typically 90 days. The fee charged is typically the same as the ongoing Administrative Fee and would only occur if your customers aren’t paying on time.

Electronic Connection Fees

Traditional providers might use their own operating systems and require the Company to connect to assist in the operational aspects of providing a facility. They will of course charge you for this connection.

Disclosure Fees

Disclosure fees are charged where the provider is disclosing to the Company’s customers that the invoices they are paying are being factored. This is most likely a message put on each invoice to each customer and incredibly, a further charge is applied for this. If the facility is a confidential Invoice Discounting facility, then a higher, Confidential Fee is applied for the privilege.

Debtor Limit Charge

Many Invoice Discount providers will have a starting limit of a maximum of 10% of the invoices from any one of your customers. This is known as a Debtor Concentration limit. Where the provider agrees to fund above this 10% concentration limit on a Debtor, they will charge you a fee for this increase and for any additional credit reports that are run on Debtors.

Breach Fees

As part of the terms of the facility, the provider may list special covenants to maintain. If you in breach of any of these, a breach fee might be charged.

So, what’s the likely impact of all these ‘hidden’ charges?

As a facility is typically agreed on an annual contract basis, what you will see below is a typical example of the ‘true cost’ of Invoice Discounting with some providers over the course of a full year when you combine headline and additional charges.

As you can see, the net impact is significantly higher than the ‘Headline Costs’ that you were sold and probably a lot higher than you thought you were signing up for!

Example

In this example, ‘Company A’ has a turnover of €6m per annum and the average payment terms are 60 days. Therefore, their average outstanding Debtor Book size is €1,000,000.

Some assumptions

We are going to assume that the provider is marketing that they will fund up to 80% of your debtor book, but in reality, after debtor concentration and geographic restrictions, this will actually fall to 65% or (a lot) lower depending on the provider.

The headline interest rate they are marketing is 5.8% AER (Annual Equivalent Rate).

All of the fees outlined in this example – both headline and additional – are based on actual proposal documents forwarded to companies by Invoice Discount providers. Some of the additional charges that are outlined above (e.g. Refactoring Charges and Disclosure fees) are not included in this example. This is because they vary quite a bit from provider to provider and it would be inaccurate to include them here. That doesn’t mean you shouldn’t make sure to ask if you are going to be charged these fees when getting a quotation

Important note: We will go into more detail on the critical ‘non-financial’ considerations that you must account for when deciding between providers, after this example below.

(a) The Headline Costs

Even at this very top level, the costs are higher than you were probably led to believe. You are not paying 5.8%, the rate you are actually paying is 8.2%.

So, now what impact will all these additional costs have?

(b) The Additional Charges

In summary, when you initially looked at this Invoice Discounting Company, you would have been excused for believing you were going to get:

A facility of 80% of your Debtor Book of €1,000,000 at a cost of €58,000 for the year (5.8%).

In fact, you ended up getting a facility at a much lower figure of €650,000 at a cost of €67,855 (10.44%).

Unknowingly you end up paying a rate that is almost double what you expected to pay!

So, what about the impact of these restrictions?

You probably entered into this funding option with the idea that you would be getting your entire debtor booked advanced to you and all you really needed to know was how much would that cost.

Right?

Wrong!

The entire point of entering into a funding solution with an Invoice Discount provider is to access sufficient funds on an ongoing basis that help fund your growth plans and manage your cashflow.

So, you probably based your expectations on the current value of your debtor book.

As you will have seen from our example above, we made a number of very typical assumptions on the rate charged, debtor concentration limits and geographic restrictions that most providers apply.

All of these have a massive impact on the actual amount that a provider will advance to you.

Let’s have a look at each of these restrictions a little more closely.

Advance Rate Restriction

A typical provider will promote that they advance up to 90% of the open debtor book at any one time. however they more typically operate in the region of 80-85%. This is typically applied before costs are deducted and gives the provider additional comfort should an individual invoice be delayed or disputed, thereby mitigating risk. So, before any restrictions are applied, the maximum amount you can possibly be advanced is already reduced quite a bit.

Customer Concentration

A very typical restriction is the exposure that these providers will agree to have on any one of your debtors. They simply don’t like the idea of funding that level of exposure. The vast majority of businesses operate on or around ‘The Pareto Principle’ aka the 80|20 rule.

The Pareto Principle states that 80% of a company’s business will come from 20% of its customers. So, the very principle of standard business practice is that you will actually have a high degree of customer concentration!!!

So, despite marketing an advance rate of 90%, assuming you do have a smaller number of key clients, they could drop the amount of exposure on these larger clients to around 50%.

Geographical Restrictions

Most growing companies in the UK & Ireland want to grow outside their original geographical location. They want to trade in new territories in order to optimise the potential of the business. That means expansion into export markets, particularly the easily accessible European and US markets. Many provider will simply not cover customers outside the UK and Ireland and, if they do, they will most likely impose a sever limit on how much of the business you do with them is covered by the facility – as low as 10% of what you trade with your International Partners.

The impact of these restrictions ultimately reduces the amount of funds available to the Company and often times means a Company is actually only every drawing down between 50-65% of the available Debtor Book at one time – despite having a 80-85% advance rate.

Also, the fixed costs associated with the facility now take on greater weight in the overall calculation and will drive up the overall cost of funds being incurred quite significantly.

Sector Restrictions

In most traditional funders, they will apply a sectoral restriction, for example set a maximum percentage that they will release on Companies they perceive as ‘risky’. This means that a really well performing company with high quality debtors can be discriminated against as they take a sector, rather than a company view.

The good news – there are many alternatives to traditional Invoice Discounting Providers

Traditional funders don’t really want Companies to think beyond the headline rates – their marketing campaigns are all designed around showing their competitiveness based purely on them.

It is probably not unfair to say that they fear the growing number of ‘alternative finance’ providers who are invading what was a ‘closed shop’ and giving companies real choice. And beginning to hurt their market share.

Let’s face it, the pricing in every industry settles to a point where in broad terms all the competitors are charging pretty much the same rate. The same is very true in Invoice Discounting. No matter who you go with, it will probably end up costing you around 10% or thereabouts per annum.

The difference is some providers will not be as transparent and honest about costs. We would recommend arming yourself with a checklist of all the costs we have outlined in this article and checking what every provider does and doesn’t charge.

Of course the rate is important, but as stated above, the end rate is likely to be pretty much the same, irrespective of who you are talking to when all costs are considered.

As stated at the outset of this article, maybe the more important questions are:

How much total funding will you be offered?

How many restrictions will be applied to your debtor book?

How flexible will the provider be to change the terms of the facility as your business changes?

A little bit about us

InvoiceFair offers a range of innovative working capital and growth funding solutions to ambitious, growing companies, including an innovative alternative to traditional Invoice Discounting with a shortened and transparent pricing system, therefore the Company is fully aware of the cost of any facility.

Also InvoiceFair does not restrict debtors, or implement geographic or sector restrictions, meaning companies will typically be able to get more funding out of their debtor books versus traditional providers.

If you’re in the market for a new Invoice Discounting provider and feel you are not getting either value for money or a sufficient amount of your debtor book covered find out how much you can release with InvoiceFair here or arrange a free consultation with one of our Funding managers here