As investors seek to diversify risk and improve their yield in this low interest rate environment, invoice factoring can offer an innovative and appealing investment opportunity. So long as appropriate and efficient credit scoring processes are in place, an investment in invoice factoring could generate outsized returns when compared to other asset classes.
The benefits of invoice factoring versus lending
One of the key advantages for invoice factoring is that it removes much of the risk of lending directly to SMEs.
When an SME borrows money directly it is often the case that the borrowing company might not perform too well in a credit score. Even though the underlying business presents attractive fundamentals, a range of factors can adversely affect its ability to borrow on sustainable terms. The firm might be fairly young, it might not have sufficient assets to secure a loan, or it could operate in an industry that traditional lenders struggle to price risk for.
Whatever the case, these concerns do not trouble a factoring company because it relies on the SME’s client, rather than the SME itself, to repay the debt.
The distinction is crucial. If an SME is supplying goods or services to a much larger customer (such as a corporation or governmental organisation), the SME can benefit by proxy from its customer’s credit rating and ability to pay.
90-day payment terms are common when dealing with large organisations, which for smaller companies can present a significant cash flow challenge. For example, if the smaller supplier has a large monthly wage bill to cover, then having to wait three months until its invoices are paid can cause operational difficulties.
Invoice factoring solves this common commercial problem and is an attractive service for the SMEs that face it. On receiving an invoice from an SME, the factoring company makes an upfront advance, usually worth about 80 per cent of the invoice value. The factoring company then assumes responsibility for collection of the debt. Once it has successfully done this it pays the balance of the invoice to the SME, less any fees charged.
For the SME this service works because not only does it receive the upfront payment, resolving any cash flow issues it might have, but it also manages its default risk. For the factoring company, the transaction works because, so long as it appropriately credit scores the invoice recipient, it can generate regular and sustainable fee income on the monies it advances and its collection service.
The business model is perfectly straightforward and because most clients of factoring companies issue invoices on a monthly basis, the potential for compounding returns on an annualised basis is clear.