Monday, 23 June 2014

The changing world of funding part 2

Asset Based Lending

In part 1 we talked about the growing importance of asset backed lending ("ABL" ) and the decline in overdraft lending. We covered ABL facilities against debtors and also touched on stock which is viewed as a more risky lend, due to the greater uncertainty around realisable values. In part 2 we will be discussing ABL facilities in a little more detail starting with a re-visit on debtors.

Debtors often form the largest class of asset against which facilities are provided. These facilities come from all of the clearing banks but also a multitude of specialised lenders. There are a wide variety of sources of debtor finance. So what are the considerations from an SME perspective.

Management need to consider how their businesses debtor book will be viewed by the lender. Factors to consider here are the size and quality of the debtor book. The incidence of bad and doubtful debts and the quality of the  customers from whom payment is due to be received. Customer concentration is also a key consideration, with lenders looking for a good spread to reduce their risk. The nature of the debts is also very important, with debtors looking for a "book" which is easy to collect out in the event that the business gets into trouble. This often precludes businesses who have long term contracts with their customers, or substantially reduces the percentage that lenders are prepared to advance. Warranties that are provided to customers are another factor which might lead to a customer holding back payment if for any reason he felt that the business maybe unable to fulfil a warranty claim. Often SMEs are asked to consider insuring, either in part, or in whole their debts which of course adds to the cost of asset backed lending.

There is now a very sophisticated market in credit insurance with many specialist credit insurance brokers throughout the country. In reality, credit insurers often  have as much interest as suppliers as to whether a business survives or fails and we now see the insolvency, and turnaround professions working very closely with the credit insurers. If a credit insurer withdraws cover then an asset backed lender may refuse to advance funds on that debtor account. This puts the supplier in an invidious position. He can continue to supply but he needs to consider that the withdrawal of  credit insurance means that the risks have significantly increased. If he continues to supply on credit the business not only needs to fund this, probably out of its own resources, but needs to fully understand the business exposure to a possible bad debt. An alternative is for the supplier to demand pro-forma payments but this may not be possible from a customer perspective.

Clearly, the percentage that an ABL facility provider might advance is a key consideration, but this also needs to be considered in light of the "clawback period". Debtor finance will only be in place for a period following submission of an invoice to a customer. The business needs to look at the payment cycle of its customers and to understand any variability and as importantly the reasons for variability in that payment cycle. Whilst and SME will have terms of trade with its customers and these might typically state that an invoice is to be paid 30 days following the month end of submission, the reality is often very different. As a consequence, a lender might have a "clawback provision" for invoices that remain unpaid for a period of anything between say 60 days and 180 days of the month end, following submission of the invoice. Clearly, from  the lenders viewpoint if it has not been paid by then, will it ever be? Sales invoices being time barred from the factoring or discounting facility can have a devastating effect on cashflow. The SME needs to keep on top of its aged debtors and to quickly understand reasons for non-payment and resolve them.

In part 3 we will be looking at further implications for SMEs in deciding whether Asset Backed Lending, is right, or not before moving on to look at other forms of funding that should be considered in different circumstances.

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