One of the biggest challenges for small to medium enterprises (SMEs) is maintaining positive cashflow. It’s not uncommon for a profitable business to experience cash flow problems, and this is especially true when the business is growing quickly. Although sufficient sales are being made, there can be a significant lag between the time when money is spent in creating products and services and when payments are received from customers.

Traditionally, SMEs have turned to banks for commercial overdrafts to get the working capital they need to fund business operations. Under this scenario, the bank extends credit to the business up to a predetermined limit and for a fixed period. The business can then make payments and withdrawals to fund its operations and smooth out the peaks and troughs in cash flow. The overdraft is typically secured by the borrower’s commercial or personal real estate.

The overdraft has for many SME owners in the past been the ‘go to’ financing tool. It is a relatively simple product and easy to administer. The primary constraint however is the strict lending criteria of most banks and the requirement to provide property as security.

As a result, a growing number of SMEs are turning to invoice finance as an alternative to commercial overdrafts. To understand why this is happening, let’s look at how invoice finance works.

What is invoice finance?

Invoice finance — also called debtor finance, receivables finance, cash flow finance and invoice discounting — is a funding solution that releases the cash ‘locked up’ in unpaid invoices (receivables) to improve cash flow and increase the working capital available to the business. Using invoice finance, the business ‘sells’ its outstanding invoices at a small ‘discount’ to a financier. The business immediately gets up to 85% of the value of the invoices which it can then put to work quickly to fund its operations — instead of having to wait the usual 30 to 90 days to get paid by customers. The company receives the remainder of invoice amounts, less a small fee, when customers pay the invoices. Without this cash flow, the business will need to turn away new business or delay investment in new stock or production until the cash is available.

The advantages of invoice finance

This simple yet effective way of improving cash flow offers a number of advantages over using a commercial overdraft facility.

1. No real estate is required as security.
A key requirement of commercial overdrafts is putting up personal or commercial real estate as security. With invoice finance, the value of the invoices secures the finance, so real estate assets are not at risk. This makes it a good tool where directors require a more equitable split of risk, or wish to minimse their personal risk altogether.

2. Get quick access to funds.
The paperwork and property valuation required for a commercial overdraft can take weeks or even months. Invoice finance can often be approved and in place in significantly less time depending on the lender. Once in place, cash is typically released within 24 hours from the date of the invoice.

3. Flexible limits which can grow as the business grows.
An important issue with using a commercial overdraft is that it’s limited by the value of the security provided. If real estate values are stagnant or rising slowly (let alone falling), the business can’t get access to more funds if they are needed to continue growing. In contrast, invoice finance can grow with the business. When sales and receivables increase over time, your business can quickly receive an increase in funds that are needed to finance this growth.

4. Higher funding limits.
Typically, an invoice financier will advance between 60-85% of the value of outstanding invoices. In most cases, the lending to valuation ratio for real-estate secured overdrafts is in the vicinity of 30-40%. Hence, more funding can often be released via invoice finance, making it an ideal solution for growing businesses. A common problem is where the funding requirement of the business outgrows the fixed limit of the overdraft.

5. Less rigidity
Real estate secured finance can suffer in times where prices are depressed due to a stagnant economy or real estate market. Additionally, in situations such as succession situations, the real estate security will need to be removed from the business by the outgoing owner, however the incoming owner may not have the required property value to maintain the required level of funding. Another increasingly common scenario is where property is used to secured the business, yet divorce requires the property to be liquidated. In such situations, invoice finance can continue the funding for the business, and allow the sale of property to take place.

6. Frees up security for other uses.
As invoice finance does not require real estate security, property can then be used as security for other uses, for example investment.

7. Based on your current position, not your history.
Approval for an overdraft facility typically includes a close look at your business history. Being a new business or having slow times in the past could affect your ability to be approved. As noted, invoice finance is based on the value of outstanding invoices. This makes it suitable for new and growing businesses that have increasing sales and good prospects but have short trading history. Invoice Finance is also a lot more flexible in terms of its criteria, and looks more closely at the value of the customer relationships and invoices as opposed to simply the balance sheet and profit and loss. It’s also suitable for established businesses that require additional working capital for growth or restructuring, or are having temporary difficulties with cash flow and need additional working capital to trade through and resolve issues. Overdrafts are also considered liabilities on the balance sheet, whereas an invoice finance facility is merely the sale of an asset, and is self-extinguishing.

8. Less paperwork.
Getting approved for commercial overdraft can require a substantial amount of paperwork. In addition to a 5 to 6-page application, you need to provide copies of certificates of titles, property valuations, 2 to 3 years’ of business financials and personal tax returns and bank statements for both trading and loan accounts. If your business is new, you will need to provide a business plan and cash flow projections. With invoice finance, the financier conducts a review of the business — including the receivables system, funding required, and the creditworthiness of the client and debtors — and tailors a solution. The financier then makes an offer. If accepted, legal documents are drawn up. The business sends its first batch of invoices to the financier who then makes funds available.

9. Bottom line benefits
Unlike overdrafts, some invoice finance facilities do provide an accounts receivable service. In some cases, outsourcing this work can be more cost effective than hiring a full time resource. Additionally, the availability of cash to the business owner via invoice finance can also mean the business can access supplier discounts for volume or early payment, helping to maintain and boost margins. At the same time, the business’ own early settlement discounts can be reduced or even completely scrapped.

The importance of cash flow for long-term business viability is often summarised by the saying “Cash is king”. In the past, most SMEs with cash flow challenges would use a business overdraft facility. But with its many advantages, more businesses are turning to invoice finance. Having grown 600% since December 2000, this form of finance now funds over $60 billion in sales per year from Australian SMEs.

Sidebar definitions
Cash flow is the difference between the amount of cash available at the beginning of a period and the amount available at the end of that period. If the cash available at the end of the period is higher than at the beginning, it’s called positive cash flow. If the cash available at the end of the period is lower, it’s called negative cash flow.

Net working capital is the difference between a company’s current assets and current liabilities. Positive net working capital is when current assets exceed current liabilities.