Invoice finance: Johnathan Dudley explains why it works for growing businesses and where it goes wrong

Invoice finance now funds a large part of UK manufacturing and distribution. On a recent episode of Legally Sound, the Ansons Law podcast, Johnathan Dudley explained how it works, why it depends so heavily on credit ratings, and why it can turn against a business when sales fall. Johnathan was a partner at accountancy firm Crowe for longer than any other partner in the firm and has spent much of his career advising manufacturers in the West Midlands. He now works with Ansons as a consultant.

Key takeaways

• Most steel stockholders and many manufacturers are now funded by invoice finance rather than an overdraft.
• Credit reference agencies effectively decide how much credit a business can get in the supply chain.
• Invoice finance works well while a business is growing, but it can drain cash quickly when sales fall.
• A change in the law on charges over book debts is a major reason banks moved businesses away from overdrafts.
• If a funded business fails, the invoice financier usually has a strong say in what happens next.
• Sector trends, changes in a company and the information it publishes can all move its credit rating, and with it the cash flow of most businesses.

What is invoice finance?

Invoice finance lets a business borrow against the money its customers owe it. The business raises an invoice, and a funder advances a large part of its value straight away rather than the business waiting 30, 60 or 90 days to be paid. The funder then charges interest and fees for doing so.

There are two main types. With factoring, the funder collects the debts from customers itself. With invoice discounting, the business keeps collecting its own debts and customers may not know a funder is involved.

"The third party give you an advance on that valid invoice on proof of delivery. And then they'll pay you the balance when you get paid, if you get paid. But they'll claw it back if you don't get paid in 90 days."

A business can insure against customers not paying, so that the funder rather than the business carries that risk. These non-recourse facilities are, however, quite expensive.

Funding is also capped. Each facility has a limit, and the funder will only advance against invoices it is prepared to accept.

Why is it so important to manufacturers?

Johnathan's view is that invoice finance is now part of the basic funding structure of industry, not a niche product. In most sectors where trade is done on credit, it has almost entirely replaced the traditional bank overdraft.

"The vast majority of manufacturing activity, in particular steel stockholding, is funded these days not on overdraft. It's all funded on receivables finance and receivable discounting."

That matters for anyone in the supply chain. If your supplier, your customer or your own business is funded this way, the funder's lending decisions affect who can trade with whom and on what terms.

"It's a vital part of the funding of modern manufacturers."

Why do credit reference agencies matter so much?

A funder will only advance money against an invoice if it is confident the customer will pay. That confidence comes largely from credit reference agencies. If a customer's credit rating drops, the funder may reduce or stop funding invoices issued to that customer.

"What is a reality is the credit in the whole of that supply chain is dictated, more so now than ever, on the ability of a company to have a credit rating."

The result is that a business can lose access to credit without any decision by its own bank. A downgrade at an agency can be enough.

"Effectively the real bankers of this world are the credit referencing agencies. If a credit referencing agency decides you're not a good risk, they will just cut their risk."

Johnathan points out that agencies look well beyond a company's own accounts.

"The attitude of credit referencing agencies, and the algorithms they use, depends on a range of data, not just an individual company's financial state. The resignation of a director, for whatever reason, can trigger a credit downgrade. Published accounts and the records they keep of late payments across the other businesses in the receivables finance network all have a part to play. Everyone's payment records are held out there and, in the age of AI, are easily accessed."

How can you protect your own credit rating?

Directors can take some practical steps to avoid an unnecessary downgrade.

• Your published accounts. Think about what the accounts you file say about the business. Micro-entity accounts, for example, give the agencies very little to go on.
• Overdrawn directors' loans. Agencies often regard a large overdrawn director's loan account as soft debt that will not be repaid.
• Late filing. Filing accounts late leaves a permanent record and is a big red flag to credit agencies. They assume late information is never good news, and they are often right, so they mark the business down.
• Shareholder loans. Do not show all investor or shareholder loans as current liabilities where in practice they are not repayable in the short term.

Why does invoice finance work best when a business is growing?

The facility grows with the sales ledger. As a business takes on more work and raises more invoices, more money becomes available to fund the next round of materials and wages.

But the reverse is also true. When sales fall, fewer new invoices are raised, so less money is advanced. At the same time, older invoices that remain unpaid can be clawed back by the funder. A business can find its cash draining away at exactly the point it needs it most.

"And that's when sometimes companies can get themselves into real difficulties."

This is where problems such as pre-invoicing tend to arise. A business under pressure may be tempted to raise invoices before goods are delivered or work is done, to keep funding flowing. That breaches the facility agreement and can expose the directors personally.

Why did banks move businesses from overdrafts to invoice finance?

For many years, banks lending on overdraft took a fixed charge over a company's book debts, meaning the money owed to it by customers. A fixed charge ranks ahead of most other creditors on insolvency.

"What banks used to do is they used to take fixed and floating charges over book debt."

Two court decisions changed that. In Agnew v Commissioner of Inland Revenue [2001] UKPC 28, often called Re Brumark, the Privy Council considered a case from New Zealand and held that a charge over book debts is a floating charge, not a fixed one, if the company is free to use the money it collects in the ordinary course of business. The House of Lords followed the same approach in England in Re Spectrum Plus Ltd [2005] UKHL 41.

A floating charge ranks behind the costs of the insolvency and preferential creditors, which since December 2020 include HMRC for certain taxes. Part of the floating charge recoveries must also be set aside for unsecured creditors. A bank relying on a charge over book debts was therefore far less protected than it had thought.

"And therefore banks immediately hadn't got any security in their overdraft. So they progressively shifted everyone on to invoice discounting."

Under invoice finance, the funder buys or takes an assignment of the debts themselves. They belong to the funder rather than the company, which puts the funder in a much stronger position if the business fails.

Who calls the shots if a business fails?

Older readers will remember administrative receivers being sent in by banks. That is now rare. The Enterprise Act 2002 largely abolished administrative receivership for floating charges created on or after 15 September 2003, and administration is now the usual route.

Where a failing business is funded by invoice finance, the funder is often central to that process. It has its own interest in collecting the outstanding debts and will usually have a strong say in who is appointed and how the business is dealt with.

"They can approve those people or they ultimately call the shots in that regard."

For directors, creditors and anyone buying a business out of administration, it is worth understanding early what the funder's position is and what it wants.

What should directors do now?

If your business uses invoice finance, or is thinking about it, there are some practical steps to take.

1. Read the facility agreement. Check the recourse period, the funding limit, the notice needed to end the facility and any termination fees.
2. Check what you have signed personally. Many facilities include personal guarantees or indemnities from the directors.
3. Manage your own credit rating, using the steps above.
4. Keep an eye on your customers' credit ratings. A downgrade on a customer can reduce your funding without warning.
5. Watch how much of your sales ledger depends on a few key customers, and reduce that concentration where you can. Funders significantly limit what they will advance against large customers because they see concentration as a key threat to the business.
6. Forecast cash on falling sales as well as rising sales, so you know how the facility will behave if trade slows.
7. Model the funding you expect to draw with a realistic discount on invoices raised, never the headline prepayment rate. Invoices disallowed for late payment, concentration or credit limits severely restrict what is available. Your actual availability history will give a far more realistic picture.
8. Never raise invoices before goods are delivered or work is done.
9. Take advice early if the funder starts reducing limits or asking for information. The options narrow quickly once a business is insolvent.

Johnathan also discusses the forthcoming Budget, the steel industry and the outlook for manufacturing in the West Midlands. Watch the full episode.

How we can help

Our Commercial Litigation team acts for businesses, directors and creditors in disputes involving invoice finance, insolvency and company debts. We can review facility agreements and personal guarantees, and advise directors whose businesses are under financial pressure.

If you need advice on invoice finance, a dispute with a funder or a business in financial difficulty, please fill out the contact form on this page, email info@ansons.law or call 01543 267988 and a member of our Commercial Litigation team will get back to you.

This article is for general information only and does not constitute legal advice. Specific legal issues always require the advice of a qualified legal professional.