As part of our 'Bookkeeping in Practice' series, ICB's Head of Learning Peter Stewart shares guidance on Invoice Financing and managing your clients’ cash flow.
Which asset would you rather have if you could have only one?
- £5,000 cash
- £5,000 debtors or
- £5,000 stock?
In your balance sheet, all three would have equal value but consider that you might have bills to pay and things to buy.
If your asset is stock, you have to wait until customers buy it and pay for it before you can make those payments.
If your asset is debtors, you know that there is some time to wait until the customers pay you what they owe plus costs and effort you may incur in chasing those payments. There is also a risk that some of the debts may prove irrecoverable.
So, cash is the most valuable of the three, despite what the balance sheet tells you.
Those of bookkeepers who have studied the ICB Level 4 Certificate in Business Insight will be aware that one of the valuable areas where you can advise clients is related to cash flow management through analysis of their business’s working capital; avoiding tying up cash in the ‘slower’ assets of stock and debtors.
One approach used by many small and medium-sized businesses is ‘debt factoring’ which may involve ‘invoice financing’.
Debt factors may offer different combinations of services and support but, essentially, they will take control of the debtors’ ledger on the business’s behalf.
One typical agreement would be that the business passes over invoices to the factor. The factor then gives the business an advance of, say, 80% of the invoice value and then goes to work to collect the full invoice value from the customer. At that point, the factor retains a percentage of the receipt as a fee and pays the balance to the business.
Before going forward with the pros and cons (which are covered in Business Insight), let’s test your bookkeeping skills!
When a credit sale of £5,000 is made, the usual double entry is:
- Debit – Debtors 5,000
- Credit – Sales 5,000
However, we know that we won’t receive all £5,000, so we shouldn’t show a debtor balance of that amount. Let’s say the factor’s fee is 5%, so £250. We know at the point of sale that that is an expense, so another journal should be:
- Debit – Finance cost 250
- Credit – Debtors 250
The next thing is that we receive that advance. 80% of £5,000 is £4,000, so that comes out of debtors and into cash:
- Debit – Cash 4,000
- Credit – Debtors 4,000
This leaves us with a Debtor balance of £750 which will be cleared at a later date when the customer settles the invoice and the factor passes the business the balance:
- Debit – Cash 750
- Credit – Debtors 750
Of course, receiving £4,750 is less attractive (in principle) than receiving £5,000. The Business Insight syllabus includes consideration of other factors that make it less clear-cut than that simple comparison. Some of them are quantifiable, others not. They include:
- The principle of time value of money. In short, receiving £100 today is better than waiting for two months to receive £100. Therefore, £4,750 now can’t be directly compared to £5,000 later.
- The ability to pay bills and buy ‘things’ now, rather than waiting. This is partly a subset of the ‘time value of money’ but we can build in goodwill retained with suppliers who we pay on time.
- Freeing up internal resources that would otherwise be engaged in credit control, trying to collect ‘tricky’ debts.
- Probable reduction in bad debts, due to collection becoming a full-time, dedicated service under the factor.
- Receiving advice from your factor about potential customers and the risk of making credit sales. The factor, who deals with many businesses’ debtors’ ledgers, will have knowledge about good and bad payers.
The Business Insight course shows you how to quantify the quantifiable components which should take you a long way to helping a business to make a decision about how to proceed when considering using a factor.
