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- Goodwill and losses should be financed by equity;
- Property should be financed by equity or long-term loans;
- Plant and equipment should be financed by asset finance over the useful life of the asset;
- Stock should be financed by a combination trade creditors, trade finance and overdraft;
- Trade debtors or receivables should be financed overdraft/revolving credit facility or invoice factoring/discounting.
The advantages of factoring or discounting compared to overdrafts or bank loans
The prudent way to finance a business is to match the type of funding to the assets being financed.
The advantage of financing a business by matching type of funding to asset life is the avoidance of pressure from Lenders to repay loans when the business can’t afford it.
However, it is not often possible to follow this prudent formula, as funds are seldom available for the longer-term requirement such as equity and long-term loans. The owners then have to consider the use of short-term funds with loans subject to performance covenants and that are repayable on demand. Owners then need to understand and manage the risk of investing in assets financed by short-term loans that can be recalled on demand by the lender.
In years gone by, bankers were prepared to finance working capital (stock and debtors) with overdrafts supported by debentures granting them fixed charges over assets and, depending on the level of risk, further supported by directors’ personal guarantees.
The distinction between fixed and floating charges is of importance because holders of a fixed charge have priority over the preferential creditors but holders of a floating charge do not. Accordingly, upon the insolvency of a debtor, a fixed charge holder will be paid out before preferential creditors. In contrast, the proceeds of floating charge assets are subject to the costs of realisation, expenses of a relevant insolvency procedure, preferential creditors, and the prescribed part (a percentage of the company’s floating charge asset proceeds – capped at £600,000). Only after these costs have been deducted is the floating charge holder entitled to receive any remaining funds.
In the case of NatWest v Spectrum Plus Ltd  UKHL 41 decided by a panel of seven members of the House of Lords, The Lords ruled unanimously that a standard form debenture used by NatWest and similar to that used by numerous other lenders created only a floating charge not a fixed charge over the book debts of the borrower, Spectrum Plus. Banks’ and other lenders’ standard procedures, which had been followed for decades, needed to be reviewed as the security of a fixed charge over book debts was no longer available. Combined with the credit crunch of 2008, banks became unwilling to lend against book debts with out other means of security.
One of the consequences of this decision is that it makes factoring and other debt purchase agreements as a means of financing a business increasingly attractive to financial institutions, as it avoids the problem of how to take an effective charge over the book debts. Instead the finance company simply takes an assignment of the debts.
Therefore, debt factoring and discounting has increased in popularity as a way of lenders funding book debts whilst retaining security over those assets. This method of finance also fits the ‘matching’ principle explained above as the line of factoring finance revolves with the creation and collection of book debts.
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