Invoice finance, where a company secures borrowing against the money it is already owed by its customers, is now the preferred method of business lending. It outstrips overdraft lending to SMEs and suits increasing numbers of businesses in the service-led economy, where debtors are often the only significant assets.
It is regarded as the optimal way to fund business growth because lending is directly linked to, and secured on, their customer’s sales ledger.
The growing importance of the invoice finance industry is clearly indicated in the latest ABFA statistics. As of the end of June 2017, the total balance of pure invoice finance stood at over £18.5 billion an increase of £2.3 billion from the same point in 20161.
Businesses are taking advantage of invoice finance as a means to scale up their operations and drive further growth, aiming for sustainable expansion and long-term profitability.
However, the very features that make invoice financing the funding mechanism of choice for growing businesses are also those that expose it to fraudulent activity which is quick to spiral out of control and difficult to detect.
With confidential invoice discounting arrangements, the lender doesn’t see the invoices and validation at audit is infrequent. Customers collect the payments on behalf of the lender which makes facilities unobtrusive, yet vulnerable to misuse.
These lending risks can see once-loyal bank customers stuck in a vicious cycle that worsens with every passing invoice submitted fraudulently.
But how does this journey from reputable customer to fraudster happen?
The precursor to fraud – other than straightforward criminal intent – is always a cash flow problem. Short-term problems such as a lost contract, an unexpected expense or simply a bad quarter of trading can provide the first push towards illegality.
A business will look to ‘play the system’ out of a sense of necessity rather than malicious criminality, unaware of the potential consequences.
The fraud starts small. An invoice is sent for funding just a few days early before the work is complete so that enough money can be drawn down to keep the lights on or to pay wages or an urgent outstanding bill.
In a few days, the work will be finished anyway and so the customer hopes to return to their regular pattern of invoicing.
However, cash flow issues are rarely one-off events. If, over the next two months another crisis begins to loom on the horizon, they will need to do it again – but this time may create an entirely false invoice.
But this fix will mutate into the need for a second consecutive false invoice in order to pay off the existing debt and avoid detection of the original fraud.
It is in this manner that the cycle of needing to create more fake invoicing to repay the first fake invoice starts.
The problem is that each time the fraudster is forced to recycle the Bank’s lending for payment of previous false invoices, the level of debt increases. This is because it is only possible to borrow 80% against the new invoices, the face value of the new invoices each time must be at least 20% more than the invoices being repaid.
What at first seemed a short-term fix rapidly accelerates out of control into an inescapable spiral of debt as the fraudster begins creating even more totally fictitious invoices to stay afloat while the likelihood of ever managing to pay off the debt recedes month-by-month.
The below case illustrates how this form of fraudulent activity can quickly get out of hand:
Say, for example, the business needs operating additional cash flow of £100,000, it will submit false invoices for £125,000 at the beginning of the year with Bank lending 80% (£100,000) to meet the cash demand of the business.
Two months later, the customer needs to repay the initial false invoices so must submit other invoices worth £157,000 in order to borrow enough to pay the original invoices and not draw attention to themselves.
By the end of one year, after six consecutive sets of false invoices the business could be borrowing over £305k against completely fraudulent invoices, all raised just to cover their tracks.
The discovery of this activity by the Bank will result, frequently, in bankruptcy, criminal charges and loss of possessions.
If the fraud can be spotted early, however, then significant losses can be avoided for the Bank and limit the scale of damage and criminality that the customer is inflicting upon himself. The traditional safeguards of audits, reconciliations and monthly facility reviews have frequently proved inadequate on their own to do this.
Certain signs that may be harmless on their own, often prove good indicators of invoice finance fraud when combined:
1. Rapidly increasing turnover
2. Fully utilised facilities and cash flow pressure
3. Requests for increased limits
4. Late submission of returns
5. Increased credit notes and fall in collections
6. Cancelled audits or key people and paperwork unavailable
7. Overly complex business structure and systems
8. Overbearing, aggressive or dominant management
9. Fosters unusually close relationship with lender
Spotting the traces of false accounting – which are laid down over time – is crucial to discovering the fraud. EQ Riskfactor’s unique software utilises a series of complex algorithms to analyse sales ledger trends on a daily basis, provides detailed insights and historic comparisons that reconciliations and audits cannot do.