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Debtor Finance Pt 2 - What you need to know before it goes wrong.

19/5/2015

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If you are considering Debtor Finance, Part 1 focused on the preparation and education required before implementation. See Part 1 Review.

From my business restructuring and business recovery experience I have seen a pattern of common mistakes and procedural failures in administering Debtor Finance and could not find any articles flagging this, so here is an opportunity to learn from real examples.

Part 2 will summarise the disciplines and processes required to maintain the benefits of Debtor Finance, after you commit, and using the experience from these examples you can see what can go wrong when certain disciplines and processes are not maintained to a satisfactory level. If you believe your processes are sound, review these examples to verify.

WHAT TO DO ON STARTING UP THE DEBTOR FINANCE FACILITY AT SET UP
  • Ensure dedicated staff are shown and trained on the Lender’s web based software on your site with your computer equipment. Ensure staff backups and a management representative are involved in this training.
  • Ensure staff in contact with customers are informed and educated on the Debtor Finance introduction and the business benefits, to intercept any misunderstandings or speculation from either side.
  • Ideally set up a specific bank account for the draw down facility. This will make reconciliations easier, and the account will show as a negative on the balance sheet “current assets” when drawn down.
  • Implement Debtor insurance if it is a Lenders condition, and review and consider implementation if it is not a condition.
DURING THE MONTH
  • The web technology allows for more than one approving party to process a draw down - use this functionality so a second person in authority or experience can maintain the overview and internal critique.
  • Have a clear list of which customers are excluded from the Debtor Finance facility. This should be defined by the Lender. Inter-company and related parties are excluded from draw downs.
  • The mathematics involved in the Debtor Finance facility can be easily supported by an Excel worksheet to correctly calculate what cash is required and available to draw down, (after applying exclusions, adjustments, credit notes and provisions), and where the threshold or date for the maximum allowable draw down will occur. Why draw down extra cash and pay interest if you do not need the cash this week? See example Excel worksheet.
  • If a cash flow forecast model is in place, and it should be if the business has had cash flow challenges, then the Excel work sheet will assist as a bridge to define the cash available for input into the cash flow forecast model after draw down. See example Excel worksheet.
  • The cash flow forecast accuracy can be improved by effective consultation with Purchasing Officers, Accounts Payable, Sales and Project Managers on the timing and values, on a frequent basis, e.g. monthly or weekly. This will further improve the information required to determine the Debtor Finance draw down required.
  • Calculate the interest deduction provision within the model as you go and adjust at month end from the statements, so the projected cash available for operations is not over-stated.

AT MONTH END


Most Debtor Finance Lenders require a reconciliation at the end of each trading month. While this should be done daily within the business, procedural issues and corrections “may” get flushed out at month end.

For example, proper reconciliations and reviews should highlight the following:

  • If customers have exceeded the Lenders set credit limits (typically 90 days), the “available draw down” amount may reduce to contain their risk.
  • If credit notes have been issued to the customer, they need to be applied also through the Debtor Finance facility.
  • Non-approved customers or related entities should not have been invoiced through the facility, and will be reversed, which will reduce the remaining funds available.
  • If customers have gone into Administration or Liquidation, they should be disclosed to the Lender and work through a practical transition solution. If debtor insurance was not in place, the amount drawn down has to be paid back or consolidated into the adjusted available remaining draw down. Non-paying customers are still a company problem and have to be monitored and expedited with or without Debtor Finance.
  • A reconciliation of the Debtor Finance provider’s records and company bank accounts should balance; investigate and resolve if not in balance.
  • Do not preinvoice, or invoice non-commercial transactions, as random audits and month-end audits will eventually pick this up – this is a breach and facility default condition with potentially serious implications.
Note: The message here is do not consume or draw down what you know you are not entitled to.

Note: Depending on the value of these issues, it is possible that the company may have overdrawn its entitlements and will owe back to the facility, or the funding may cease until the disparities self-correct from future debtor receipts. This means a period will occur when no cash flow comes into the business.

MONITORING DEBTOR FINANCE

The following are tips on good practice to manage, monitor and control the administration of Debtor Finance, to ensure continued reliable cash flows from this facility.

  • Have back up staff trained to do the Debtor Finance draw downs and bank reconciliations. Ensure leave plans are monitored to anticipate this. Rotate staff in this role to keep alert and to provide peer reviews. Do not leave the whole function to one person; as illness, personal emergencies or sudden unexpected departures can occur.
  • Management, or a person in authority or experience with an understanding of the process, to be an internal approving party in the web draw down process.
  • Monitor and expedite slow paying customers – stop supply in extreme cases. Just because cash was drawn down on invoicing should not reduce the diligence to monitor accounts receivables.
  • Ensure a Debtor Finance spreadsheet is used and maintained daily to assist the traceability link between the facility, your bank account and the cash flow worksheet inputs. Calculate and make provision for the interest, charges, adjustments and exclusions. See example worksheet.
  • Draw down on the debtor finance facility only when you need it – why pay extra interest if you do not need to?
  • Ensure monthly management financial accounts are done timely, accurately and every month.
  • Ensure key files are backed up regularly. Include backing up key finance files on mobile office equipment on the office network – verify this has been done.
  • If you need to rush Debtor Finance invoices through each week to ensure you have cash to pay the wages, then take the hint and implement effective corrective action to identify and resolve what is causing the cash short fall.
  • Ensure debtor credit notes are also applied to the draw down facility.
  • Do not invoice non-approved customers, related entities or any of the Lender’s excluded parties.
  • Do not pre-invoice for work not-earned or where the customer has not agreed to be invoiced.
  • Just because the Lender may have done an audit and nothing was detected, does not mean your system or management process is sound. If the auditor missed a breach or transaction error, the underlying problem is still with the company not the Lender, and the audit is not a defense.
  • Ensure debtor finance monitoring reviews are on the Board or risk management committee agenda.
  • Develop and maintain a simple KPI dash board monitoring key financial and operational ratios – this will provide improved visibility and understanding of key drivers and related affects. See some working examples.
If these basic and prudent disciplines are maintained, then the accelerated cash flow benefits from Debtor Finance will be achieved and sustained with no surprises or adverse cash flow corrections.

WHAT HAPPENS IN DEBTOR FINANCE AUDITS AND IF DEFAULTS OR BREACHES OCCUR?

Usually if a procedural issue exists it will occur or develop within the first year. Some Lenders may do audits annually but this is too long to wait for someone to discover issues – a lot of damage could have progressed (e.g. incorrect draw downs), and some companies have not been able to recover from this because the cash had been consumed.

Audits usually check random transactions, evidence of controls and reviews, validity of invoices and amounts, and verifying if non-approved customers have been included etc.

Always be transparent and honest with your issues and disclosures to the Lender. If you have been, and if issues arise, you are more likely to get support or concessions to work through the issues. Conversely if the facility has been manipulated, information withheld, or false claims made, then the Lender will enforce the agreement conditions and abrupt stops to cash flow can occur.

In the event that the facility has been overdrawn, and based on the cause and the quantum, and the risk exposure to the Debtor Finance Lender, typical tactical responses by the Lender are:

  • Ceasing any further draw downs until the debtor arrears are paid (to the Lender) to bring the outstanding amounts back into the approved facility limits.
  • Converting the arrears into loans, usually at higher interest, with this then showing on the balance sheet "liabilities".
  • Arranging for an independent Investigative Analysis review on the business, where adverse findings may trigger other events.
  • Enforce Director Guarantees or Personal Guarantees, increasing personal liabilities.

SUMMARY


Part 2 has drawn from real examples to provide a checklist on processes and controls that should be in place to manage the business, and to provide an effective framework to better manage Debtor Finance and cash management.

If these processes and checks are followed then the accelerated cash flow from the Debtor Finance facility will continue to provide the original benefits, with no surprises.

If business conditions adversely change, act early and seek additional independent professional advice as required.

If you are aware of other procedural failures or additional disciplines required to maintain or improve the control of Debtor Finance, please feel free to share them in the Comments response, so others recipients can learn from your experience.
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Debtor Finance Part 1 - What you need to know before you commit.

19/5/2015

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Many businesses are struggling to adjust to changing (and in some cases contracting) market conditions with one of the direct affects being a change and reduction in cash flow.

One of the solutions being promoted and growing significantly in recent years in the Australian market, is implementing Debtor Finance (sometimes termed Factoring or Cash Flow Financing).

In the right framework, Debtor Finance can be a sound strategy to improve cash flow. In the wrong framework, serious issues can occur.

From my business restructuring and recovery experience I have seen a pattern of common mistakes and procedural failures in administering Debtor Finance and could not find any articles on this, so here is an opportunity to learn from real examples.

This 2 part review is provided to improve the understanding and application of Debtor Finance.

Part 1 will focus on the preparation and key issues to consider, before implementing Debtor Finance for those who are not experienced in this area. As always, seek independent professional advice for guidance when in doubt.

Part 2 will summarise the disciplines and processes required to maintain the benefits of Debtor Finance, after you commit, and using the experience from real examples, shows what can go wrong when certain disciplines and processes are not maintained to a satisfactory level.

What is Debtor Finance?

The main purpose of Debtor Finance is to provide a line of credit if the business cannot provide 30+ day terms to customers, and this funding was designed only to address this specific type of cash flow problem.

In “standard” businesses, invoices are presented to customers to pay for products and services within agreed payment and credit terms (often 30 – 60 days from end of trading month). However that means potentially 60 days (or more) pass from commencement of the job before the cash comes in, and prior to this wages are often paid weekly and suppliers paid, before the customers pay.

With Debtor Finance, the invoice is issued to the customer and the lender, and the lender typically advances 70% - 85% of the invoice on presentation within 1 or 2 days, and deducts this advance less interest and charges when the customer finally pays.

Debtor Finance lenders will “own” the debtor invoice as security, while bank Debtor Finance lenders often additionally require personal guarantees and security charges over fixed assets. Formal application fees are typically a one off $3,000 to $5,000 but can vary, and the interest charge is higher than bank overdrafts. Debtor Finance providers often have their own funding provided by a bank.

There are options and processes available to disclose or not disclose (termed “Confidential”) the use of a Debtor Finance facility to customers, and who has the responsibility of collecting the trade debt (the company or the lender).

Debtor Finance funding providers consider the credit-worthiness of the customers, where a bank also makes credit decisions for loans based on the financial history, bank loan(s), cash flow and security of the business. As Debtor Finance funding is not a loan, the liability on the balance sheet is not shown as a “liability”, but deducted from “current assets”.

The simple benefit analogy when introducing Debtor Finance is the business gets a one off cash advance injection, equivalent to 1 month of trading, and maintains this advance. Lenders usually require a minimum 1 year arrangement, but for cash flow constraints is often difficult to trade out of once signed up, if business has not improved through this period.

What to do before making an application for, or implementing Debtor Finance?

Preparation and increasing the knowledge of this facility and how it works is critical.

Some suggestions are:

  • Review why Debtor Financing is required. If the business is contracting or not providing adequate profits then there is another issue to resolve, find the root cause and seek assistance as required to correct first. Debtor Finance is not a solution for cash burn or losses.
  • Speak to other businesses that are already using Debtor Finance - what have they experienced?
  • Modify or develop a weekly cash flow model with and without Debtor Finance, test scenarios with different business assumptions, and calculate the projected closing bank balance and convert to graphs, this will improve the understanding and cash flow impact on the business with these comparisons. See comparative examples
Include interest (calculated daily on the amount of funds drawn down), application fees and administration charges. This will assist to determine the upper facility cap required, and trial the impact of seasonality and slow paying customers. Do not include related parties (where a customer may also be a supplier and vice versa) or inter-company trading – they are excluded from funding support.

You will note that a specific profit level is required before the cash flow improves as the additional interest expense consumes some of the cash gain. What is this minimum profit break-point for the business scenario to get a cash flow gain – this will vary for each business and sector? See comparative examples.

  • Ensure the business can cover the additional interest charges.
  • Before implementing Debtor Finance, inform your bank manager, as the new PPSA (Personal Property Security Act) process will result in the Bank being informed anyway. Communicate with and manage your financial stakeholder(s) so there are no surprises.
  • If your bank provides Debtor Finance, review them as a possible provider, and compare rates and charges. Use the competitive options to suit the business needs.
  • Consider the resource and skills required within the business to cater for the additional internal administration. What is the impact if an additional 1 – 5 minutes of resource is required per invoice per day? Do you have a backup resource if the key person is away?
  • Ensure key staff (including the Board and sales) understand why Debtor Finance is being implemented, and the benefits and internal and external challenges this may introduce.
  • Are there other options available to fund the working capital requirements to avoid the use of Debtor Finance, for example reducing inventory and WIP, or getting extended trading terms from suppliers? Are a specific few customers causing cash flow problems and have you engaged with them to resolve or find a commercially better solution, e.g. offer a discount if they pay early?
  • Does your internal and external accountant understand Debtor Finance, and how it affects the balance sheet and integrates with a weekly cash flow worksheet?
  • If not in place, consider debtor insurance to cover bad debts and what is the fee? Some Debtor Finance lenders require this as a mandatory condition of lending.

Debtor Finance – what is assessed in the funding application?


Assessments for Debtor Finance approval usually considers:

  • Creditworthiness of the business’s commercial customers.
  • Industry type – influenced by the lenders risk assessment of the industry.
  • Payment cycle from customers.
  • Transaction volumes – the number and value of invoices per day.
  • Minimum sales turnover, typically a minimum of $1M PA.
  • Business profitability.
  • Trading history – usually require 1 – 3 years of financial accounts.
  • Current and foreseeable trading issues.

Debtor Finance funding will not cover:


Debtor Finance facility providers will exclude:

  • Export customers – alternative facilities and options are available.
  • Related parties – where a customer is a supplier and vice versa.
  • Inter-company or related entity sales.
  • Short payment cycle customers, e.g. cash or 7 day accounts.
  • Specific customers or industries considered high risk, or with low margins.
  • Industry types often excluded are building contractors, professional services and retailers.
  • Payment for purchases – there are other funding facilities available if this is needed.

Part 2
will focus on the process and administration required to ensure Debtor Finance benefits and risks are managed, and some real examples where serious implications and negative outcomes can occur.

It is important for management to consider Debtor Finance, like any form of finance, if it is suitable for the business and carefully consider the pros and cons and how the accelerated cash flow is to be effectively used. As always, seek additional independent professional advice as required before you sign up.

If you are aware of other preparation or pre-screening experience, please feel free to share them in the comments response, so other recipients can learn.
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