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Debtor Finance Part 1 - What you need to know before you commit

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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