Asset-based finance

Asset-based finance, or ABF, is a collective term used to describe invoice finance, and asset-based lending. Invoice finance includes factoring, invoice discounting and supply chain finance.

All of the four main forms of asset-based finance can be used to release cash flow for the business to use as needed.

Factoring is used by smaller SME businesses to support cash flow by generating money against unpaid invoices. It is available to businesses that sell products or services on credit to other businesses.

Factoring involves selling accounts receivable or unpaid customer invoices to a debt factoring provider – a ‘factor’. The factor then owns the debt and chases payment from the customer.

The factor will advance the majority of the value of customer invoices (usually 80-90%), with the balance made available once invoices are paid, less charges.

Given that customer credit is based on net-30, net-60 or net-90-day terms, it is one, two or three months before a business is paid for its work (and that is when customers pay and pay to terms). Factoring improves cash flow by assuring invoice payment much sooner.

Factoring fees are known as a discount rate and are typically between 0.5% and 5% of the invoice value per month. The discount rate is charged either weekly or monthly, so the longer it takes a customer to pay, the higher the total factoring cost.

The cost of factoring will be more than a conventional loan when the annual percentage rate (APR) is calculated, but there is a difference in the total cost because in factoring you are borrowing the cash for such a short period of time.

Factoring combines the provision of finance with a service element, helping the business with credit control, which can be particularly valuable for smaller businesses. The factor works on behalf of the business – managing the sales ledger and collecting money owed by customers. This relationship is transparent, and customers of the business will be aware that a factor is involved.

There are two types of factoring:

• Recourse factoring. Liability for payment of the invoice remains with the business, which has sold its invoices to the factor. If the customer does not pay after a specified period, the advance and the factoring company’s fee must be repaid.
• Non-recourse factoring. The risk of non-payment passes to the factor and is typically more expensive. If the customer does not pay, the cash advance is retained by the business, which sold its invoices and the factor takes the loss. A non-recourse factor will be far more interested in a customers’ creditworthiness.

Export factoring is also available to support businesses selling internationally.

For a small growing business, credit control and managing and chasing up invoices can be expensive. Debt factoring can free up constrained resource to be used elsewhere in the business.

Where sales are regular, debt factoring provides smooth availability of cash flow to fund operations and potentially investment in plant and equipment. However, some small businesses can become reliant on debt factoring to finance working capital long-term, and it is a more expensive way of borrowing.

There is also risk involved in handing over this interaction with customers over to a third-party focused only on collecting cash. It may make sense to use factoring for some customers and not others, if this is an option.

Invoice discounting is similar to factoring, but can be more appealing to larger businesses for two key reasons:

• The business retains control over the administration of the sales ledger. In this way, the invoice discounting company will remain a “hidden partner”, which may appeal to businesses for a variety of reasons. Customers of the business will continue to be invoiced as normal, and the financing relationship is purely between the business and the invoice discount provider.
• The funding provided tracks the growth in the business – increasing turnover unlocks more funding.

Supply chain finance, sometimes called reverse factoring, is where smaller suppliers can take advantage of the credit strength of larger customers. It provides short-term credit that optimises working capital for both the buyer and the seller.

Instead of relying on the creditworthiness of the supplier, the lender deals with the buyer reducing its risk. Suppliers effectively sell their invoices or sales receivables or debtors, at a discount, to banks or other financial providers, often called factors.

Although they do not receive the full amount, suppliers get faster access to the money they are owed. Meanwhile the buyers get more time to pay and can potentially negotiate better terms from the seller.

Supply chain finance requires the involvement of the supplier and their customer, and up to 100% of the value of invoices can be funded once they have been approved by the customer, often at more competitive rates than would otherwise be available.

Supply chain finance is a technology-based business and financing process, which links the three parties to a transaction. It can be accessed directly through some larger organisations and also through a growing number of alternative providers.

There are also several variations to supply chain finance transactions:

• extension of buyer’s accounts payable terms;
• inventory finance; and
• payables discounting.

In the past, asset-based lending was seen as a more sophisticated product for larger SMEs and mid-sized corporates. However, it is now increasingly available for smaller businesses as well.

Asset-based lending is provided on a similar basis to invoice finance, with funding extended against debts. But in an asset-based lending arrangement this is complemented by finance against a wider pool of assets, typically including stock, property, plant, machinery and sometimes intangibles such as intellectual property or forward income streams. This maximises the cash available to the business to support future plans.

Asset-based lending can also be used in mergers and acquisitions, management buyouts and turnarounds.

• Case study: Brighton Gin
• Case study: Siren Craft Brew

• Visit the UK Finance website
• How to find the right financial advice
• Download the ICAEW’s latest guide to Growth through Asset Based Finance.