Asset-Based Finance: a Guide for Small Businesses

Obtaining the right kind of finance to expand and grow your business is a constant pressure point for small business owners. With the high-street banks less willing to lend to small businesses than they once were, it’s forced companies to look elsewhere for the funding that they need.

Fortunately, there are now plenty of options available to small businesses beyond the banks, thanks to the emergence of alternative finance. As well as peer-to-peer (P2P) and online balance-sheet lenders, which can facilitate funding in a matter of days, another form of alternative finance that’s proving particularly popular is asset-based finance.

All small business owners looking to diversify the funding they have available to their business should consider whether asset-based finance offers the flexibility they are looking for with their financial arrangements. However, it’s worth noting that asset-based finance comes in numerous forms, including:

• Factoring
• Invoice Discounting
• Asset-based Lending

Business owners should take the time to assess which type of asset-based finance is right for them.

What is factoring?

Factoring companies advance a percentage of the value of outstanding invoices to your business. When the invoice is settled, the rest of the invoice value – minus the factor’s fee and other potential costs such as bad debt provisioning – will be paid to your company. The factoring company essentially acts like an external credit control service, chasing your customers for the settlement of invoices, and processing payments. This means that your debtors are aware of you having this facility.

Advantages of factoring

• Factoring offers fast access to cash. After the system is initially set up, funds can start to flow into your business within one or two days.
• The factor takes control of your sales ledger and chases your customers for payment. This frees your time and resources to build your business.
• With instant cash available, your business can grow, as it has the funds it needs to expand, without the delays that often come with other forms of funding.

Disadvantages of factoring

• The rates (e.g. APR) charged by a factor will invariably be higher than what a bank charges for a traditional loan. This means you can expect to pay more for a factoring facility than you would for a more conventional form of finance.
• The time from making your application to receiving your first payment can be longer than you think as the factor may want to review your existing debtor book.
• The majority of factoring companies will place a credit limit against each of your clients, which might be less than the total value of invoices. If you breach this amount, then anything above the agreed limit will not be covered, which could lead to you having an exposed credit facility.
• Customer relationships can potentially be damaged if the factor acts in a manner that upsets your client, in order to get your business’s invoices settled.
• Factoring is not ideal for cash-based businesses, or companies that are consumer-facing. Factoring works best with business-to-business sales, as the terms and conditions will state the date when an invoice becomes due for payment, e.g. 30 or 60 days from the date of invoice, or from the end of the month it was issued.

What is invoice discounting?

Invoice discounting works in a similar way to factoring, albeit with one key difference. As with factoring, the invoice value minus a fee and any other associated costs is advanced to your business, but you’ll retain responsibility for chasing invoices, rather than a third party.

Advantages of invoice discounting

• Businesses that don’t have assets they can use as security can still use their invoices to secure the funding they need.
  
• As you’ll still be in charge of your credit control function, it means your clients won’t be aware of the fact you are using a factoring service.
• The level of funding available is directly linked to a business’s sales. As these increase, you’ll have access to additional funding should you require it.
• Additional services are often available, such as protection against bad debt or the running of payroll systems to free up more of your time to look for new customers.
• It's an incredibly quick way of obtaining finance for a business, with a reduced need for overdrafts or other debt facilities.

Disadvantages of invoice discounting

• Invoice discounting is designed for business-to-business trading, not for consumer-facing firms. If you only deal with consumers, and thus don’t have any invoices, you won’t be able to access this type of finance.
• Businesses need to meet certain criteria to be accepted for an invoice discounting facility. Many invoice discounting companies will require a company to have a high level of turnover and at least one blue chip debtor.
• The cost of invoice discounting can vary depending upon your debtor book quality and levels of aged or bad debts.
• As an SME grows, its invoices normally increase in size, so the business needs to ensure the agreed credit limits set by the factoring company continue to reflect their business requirement. This can mean ongoing dialogue with your factor.
• Businesses can become over-dependent on invoice discounting to maintain their cash flow. Invoice discounting is not a replacement for robust and efficient credit control.

Customer relationships can potentially be damaged if the factor acts in a manner that upsets your client, in order to get your business’s invoices settled.

What is asset-based lending?

The basis for this kind of lending is to secure the loan against a wide range of assets. These could be stock, property, plant or machinery, and even intellectual property. If a business defaults on its payments, an asset-based lender can seize the asset from the business, and sell it to pay off the remaining debt.

Advantages of asset-based lending

• Because the lending is asset-based, it means your business can invest in assets, knowing it can raise against them if required.
• Asset-based loans often having less stringent qualification criteria, which can make this form of finance quicker and easier to access.
• Asset-based lending can be used as a stepping stone to other forms of credit. This is often easier for new businesses that are building up their creditworthiness. Even at an early stage, a business might have assets it can borrow against, such as vehicles, stock or machinery.

Disadvantages of asset-based lending

• As the loan is secured on your business’s asset, in the event of a default, the asset would be seized. This could have a major impact on your business’s ability to trade, and could even leave you owing a debt if the asset's sale price doesn’t cover the outstanding loan.
• If the assets you want to use as collateral are given a low valuation, it could substantially reduce the amount of funds you're able to obtain. In addition, if your asset increases in value, your loan limit will not increase accordingly.
• Costs can be high when your asset has limited appeal or is industry-specific. Additional fees and the cost of potential ongoing administration can increase overall costs to the business.

Alternatives to asset-based finance

Asset-based finance is, of course, just one way your business could secure the funds it needs. If asset-based finance isn’t possible for your business, or it simply doesn’t fit your ambitions, alternatives such as unsecured loans, lines of credit, overdrafts and revenue-based finance could be more appropriate.

The key is to look closely at what kind of finance your business needs and what you intend to use the money for. Factoring and invoice discounting can be ideal to free your cash flow, for instance, but a secured or unsecured loan, an overdraft, or a revenue-based finance facility could be more useful. However, look closely at the cost of each type of finance and the terms and conditions under which you are agreeing to the loan. Don’t forget, for example, that overdrafts are repayable on demand from your bank.

By thinking about all of the available options, you’ll be able to identify the most affordable type of lending for your business.

If you want more information on the alternative finance options which Fleximize offers, take a look at our business loans page or application process.