None of us particularly like money-lenders and few of us would want the stress and unpleasantness of being the type of money-lender that proliferates in cities like Kampala – leeching returns of 10% a month against assets pledged by desperate borrowers. The reason that these bloodsuckers can exist is that access to credit on reasonable terms, or at all, from banks is still so difficult to get for most businesses.
The fact is that there are some great businesses that cannot grow and often struggle to survive because cash-flow is such a huge problem. In Europe many businesses use “factoring” to improve their business cash-flow and reduce the time they spend trying to collect money. But the truth is that the banks that provide this service are so selective about the businesses they deal with and the invoices they process that the service is unwieldy. And that is where a mutually beneficial opportunity exists for both cash-strapped East African businesses and investors wanting a better return on their money.
The Service – Invoice Factoring
Factoring is a type of short-term accounts receivable financing, where you effectively ‘sell’ your outstanding invoices to a third-party. Sometimes, there’s a gap between when you finish a job and send an invoice and when the client returns payment and this is where invoice factoring can add value.
The terms of factoring deals are different in many situations, but most factors advance businesses between 60 and 80 percent of the value of the invoices. You get your cash, and the factor takes on the responsibility for getting payment from those customers, managing the credit control of the business, and processing invoice payments. This means that your customers will be aware of your relationship with the factor.
With factoring, the factoring company takes over the management of your sales register and credit control process. They also actively chase customer payments on your behalf, meaning you can do away with the time and cost of credit checking your customers, which is especially important if credit control has been poor in the past. You are given advance funds for individual invoices. Any adjustments to the funds you receive are made on a day-to-day basis.
- The finance company will look after your sales ledger, administer the credit control process, and chase payments, freeing up your time to manage the business.
- Excellent credit checking processes mean you are more likely to trade with customers who pay on time.
- Working with a factoring company can sometimes help you negotiate better terms with your suppliers.
- Your customers may prefer to deal with you directly.
- The additional services provided by a factor do come at a cost. The management fees for a factor can be anything from 1.5 to 3.25 percent of turnover.
Any business which invoices from 30-90 days would be a typical candidate for accounts receivable financing. Equally, a business which has a smaller number of clients owing a higher value of invoice means there is a particular cash-flow vulnerability to late payments.
Certain industries tend to utilise invoice finance more than others, including:
If you have a smaller business that has had problems with credit control and collecting payments in the past, for example, factoring is a very good option.
The Investment Opportunity
So, factoring as a concept is pretty straightforward. Company A does the work for Company B. Company A´s bank invoices Company B and advances Company A the majority (60-80%) of the money they are owed. The bank collects the money and passes it on to Company A minus the money it has advanced, the interest on that advance, and the fees for operating the service.
In practice the banks make it much more complicated. They do not allow “concentration” beyond 25% of the facility so if you have a small number of big spending clients then the bank will only advance 25% of the invoice total. They underwrite every client and every invoice separately, and they are probably less effective at collection than you are. They also do not like certain industries and certain products and so, as always, they hold all the cards. They have made a very simple service way more complicated that it needs to be.
That level of complexity, the banks’ attitude to clients, and the very high charges mean that most East African businesses, particularly the smaller ones, do not consider factoring a viable option.
K.I.S.S. is an acronym that is close to my heart. It stands for “Keep It Simple, Stupid!” And I genuinely believe that there is a great opportunity to make this easy for the business-owner and profitable for the investor. It does not involve vastly complicated systems and offers a fair deal to both the business and the investor. It is also far less risky than a simple loan. It works like this:
- As an investor I offer businesses that I like and trust an invoice factoring service on an invoice by invoice basis.
- If I like the business that is supplying AND the business or individual who is purchasing I agree to the transaction and I invoice the purchaser directly.
- Once the invoice has been accepted by the purchaser I pay 60-80% of its value to the supplier immediately.
- I then collect the invoice payment in full from the purchaser.
- I deduct my charges for the service – say central bank rate (Uganda 8% pa today), plus a margin of say 4% pa, plus a 2% processing fee.
- a brick-making company sells 200,000 bricks at 300 Ugandan Shillings (UGX) each to a builder – a total invoice of 60m UGX.
- I confirm satisfactory receipt of the goods and advance 60% of the invoice value (in this case all the manufacturers cost) to the brick-maker who receives 36m UGX.
- I chase payment of the invoice which is made 45 days after the invoice is sent.
- I deduct the processing fee of 1.2m UGX and the interest fee on the 36m UGX advance (calculated monthly) of a further 720k UGX and send my client the balance of 22.08m UGX.
The buyer got their bricks; the manufacturer got all his costs covered immediately and did not have to chase for payment; and I made 1.92m UGX on a loan of 36m in 45 days (a return of just over 5%). Annualised this would make me more than 43% per annum – and I pick the products I lend on, the people I lend to, and the clients I collect from.
Most importantly the relatively low cost of credit and the immediacy of working capital make this a brilliant option for my brick-maker. What´s not to like??!!
Jon Pedley is Chief Operating Officer, Investment Owl. For more information on this or anything financial contact [email protected]