In the fashion industry, quick and ready cash flow is essential. If a client hasn’t paid an invoice on time, a small business can suffer greatly from lack of immediate capital to draw upon. Problems arise when low sales periods coincide with periods of intense manufacturing, and business owners simply cannot wait for money to come in via traditional invoicing, which can often take up to three months. Banks are often reluctant to provide loans to newly established fashion labels due to the uncertain nature of the industry. Banks rely on collateral and safety – something which will provide security to the loan, and something that new small businesses quite often cannot offer unless a family home is used.
With traditional forms of financing often unavailable, these businesses can turn to a range of business finance options in order to secure virtually immediate cash flow. Business finance solutions offer small businesses the ability to convert a debtors ledger into cash immediately. Without a business finance arrangement, a fashion designer would have to wait for debtors to pay the invoices to gain cash flow to start manufacturing more garments for further profit. This halts production and can be crippling to expansion.
With a business finance arrangement, the fashion designer can produce the garments, sell it into retail then immediately get around 80% of the invoices back from their finance provider. With that cash flow, manufacturing can continue. The finance provider has taken on responsibility for collecting the debts and pays the balance to the designer upon receipt, minus a fee for their services. Business finance companies work alongside their clients, and the clients benefit from having a dedicated credit controller who, in effect, becomes an extension of the client’s team in collecting, managing and administering debt.
Finance companies offer a range of services for business finance, the most common being debtor finance. Scottish Pacific Business Finance, for example, provides five different business finance services:
- Debtor finance, as above
- Export finance – helps businesses create relationships with overseas clients in the same way as debtor finance, tiding businesses over with capital until debts are paid
- Import finance – allows small businesses to import products, facilitated by small loans
- Bad debt protection – essentially a consulting service, wherein the company will investigate potential customers and give advice about what sort of credit lines should be extended
- Selective invoice finance – a more basic ‘come and go’ version of debtor financing, where clients can select up to ten invoices to fund immediately.
Wayne Semmens, Business Development Manager of Scottish Pacific Business Finance, says that there are two main advantages of business financing, the first is being the lack of requirement for real estate security.
“Invoice Financing is a more flexible form of finance as the amount of funding available is based on the sales you make, not on the value of your historic balance sheets. The facility grows in line with business growth, no there is no requirement to go cap in hand to the bank seeking to increase existing fund lines.”
The second advantage, says Semmens, is versatility and the ability for business financiers able to support the client through a wide range of situations and at various stages of the business lifecycle. “Rapid growth, turnaround, mergers and acquisition, management buyouts, financial planning applications and even divorce scenarios where co-owned property has been used to secure business finance.”
Furthermore, Semmens says that “when matching like for like, invoice financing offers value for money in comparison to bank funds, where the cost of money advanced is highly competitive.”
Banks are less flexible in their lending arrangements than other finance companies due to their insistence on safety and security and often the need to have real estate as collateral to hold against the loan. To even get an overdraft can be difficult for a small business, especially when capital is low and physical property is limited. However, there is a growing trend towards banks providing similar services to online lenders in regards to debtor financing.
The main reason behind this is the removal of the need for security. Once the small business owner and the bank have entered the arrangement, the bank owns the invoice – that is, they now have the right to claim all the money back from that invoice and some banks, such as BNZ, deem the need for further security unnecessary. However, there is still an associated risk as there is never any guarantee that the debtor will pay back the amount owed, in full or at all. Because banks often prefer to operate in low-risk fields, the criteria to be eligible for debtor financing from a bank will sometimes be out of reach for new businesses operating on small amounts of capital. The BNZ lending criteria require a minimum annual credit sales total of $2 million with a minimum finance amount of $200,000 – again, something that a start-up business owner may not be able to achieve. In light of tightening credit lending criteria, businesses are now exploring alternative options to banks.
In the past, there has been a certain stigma attached to being reliant on business financing. It was perceived as a sign of a failing business, the consequence of a business owner who could not keep control of their debt collection. Business financing is now a $60 billion industry in Australia and financing approximately 15% of GDP in the United Kingdom, with significant growth in the New Zealand market.
Much of the social concern resulted from a lack of subtlety on the part of the business finance companies. Small business owners would be reluctant to pass debt collecting responsibilities to a third party when doing so would reveal to their clients that they are using a financing company. Managing debtors can be time-consuming and costly – an unfortunate necessity which emerging businesses simply cannot cover. This problem is compounded when debtors are exceptionally late, and cash flow upon which businesses were relying is unavailable.
Furthermore, finance companies now place greater emphasis on anonymity. Clients are able to give their debtors a bank account number ostensibly under their name, when in reality it belongs to the finance company. This small measure means that the former stigma attached to relying on finance companies is not longer a concern.
Business financing is necessary for businesses where growth outweighs cash flow. Over time, the perception of business financing has experienced a shift from being regarded as a sign of instability to an acknowledgement of economic common sense. The other option is to restrict orders but, in an industry where competition is stiff and demand must be met, this could spell certain disaster for a young business.
For all its advantages, there are risks associated with small business financing. While business finance solutions can provide a quick source of income, it does come with associated fees which must be built into the already existing cost of running the business. However, greater risk comes from finance providers misleading small businesses and having them sign up to finance options with hidden fees.
Simon Thompson of Cash Flow Funding said that his pet peeve is lenders advertising misleading rates when offering small loans. The global financial crisis in 2008 saw the demise of a large number of non-bank finance companies, which hit SME borrowers hardest as it vastly reduced their options for business financing. Small business owners were unable to afford the costs of the larger financing companies while also struggling to secure finance options from banks. This has led to a rise over the last decade of online lenders with a focus on convenience and speed, such as SpotCap and Get Capital.
The problem, Thompson explains, is that borrowers are not aware of the true rates of interest they end up paying for these online loans. Lenders typically offer short-term principal and interest (P&I) loans with very high ‘true’ rates – rates which can often be obscured by clever marketing.
Thompson gives this example:
You borrow $10,000.00 for 12 months with monthly repayments of $917.00.
Repayments (12 x $917.00) $11,004.00
Amount Borrowed $10,000.00
Cost of Funding $1,004.00
Clever marketers would tell you have only paid interest of 10.04%. But this is the flat rate. The true cost of finance is actually greater, because monthly repayments include both principal and interest. True rates are important because they are an effective way to make apples-to-apples comparisons.
The new generation of online lenders tend to focus on speed and not cost, and therefore borrowers often don’t understand how expensive their loans are. It is very rare for online lenders to advertise their true rate because there is no legal requirement for them to do so, unlike consumer finance contracts where the true rate must always be disclosed. This is why small business owners are particularly susceptible to falling victim to unfair lending schemes. Without full disclosure, it is misleading to the borrower and favourable for the lender who makes it seem as if they are offering low rates.
Thompson recommends that borrowers shop around, and most importantly ask what the true rate is before making any decisions about finance companies.