You may have heard of this form of financing, but aren’t sure what it is and if it’s an option for your business. So let’s answer some of your questions.
What is debtor finance and why should a SME consider using it?
The basis of debtor financing is that you use the debtor (normally an invoice) to raise capital against it. The major advantage is that you do not have to wait for your debtor to pay you. You raise funds against the invoice, so you have working capital to be used in the business.
Is debtor finance only raised against invoices or are there other options?
There are many different types of debtor finance, for instance:
- Disclosed factoring: where the debtor will be informed that the account was factored to a third party, but this could create a negative perception with the client.
- Undisclosed factoring: a method of raising funds against debt, without the client knowing. The agreement is therefore between you and the financier.
It is important to be very clear on who will control the administration of the debt. In some cases, the business owner remains responsible to collect the debt and to do so within the required time.
Where the financier is taking control, the owner could be concerned about the relationship and effective management of the collection process.
When does it make sense to use debtor finance?
It is ideal:
- To improve the cash flow of the business by freeing up money tied up in trade debtors
- For high growth or seasonal businesses
- When the business is growing and cannot afford to carry debtors from the normal internal cash resources
- If the business has a large once-off sale or even peak sales (due to a large order or contract) and this negatively influences the cash flow. The business will then require funding to bridge the period between incurring the costs and receiving payment
- When the client insists on extended credit terms (say 90 days instead of the normal 30 days terms), and will therefore only pay the debt over a longer period, there may be a need for debtors finance
Some other advantages are:
- The factoring house can offer other services such as debtors’ administration
- The invoice forms the basis of the security, so other collateral, such as fixed property, may not be required
- Freeing up cash flow can have increased profit benefits, including capitalization on lucrative trade discounts
Surely there are also disadvantages associated with debtor finance?
Yes, there are always two sides to a coin. The down side is:
- Loss of control over the administration process and therefore you are unable to directly manage the relationship with the client
- Perceived negative perception from a client when using disclosed factoring
- The associated costs; over and above the interest they charge, these include activation fees, annual review fees and administration fees payable
How common is debtor finance?
The main reason that factoring in South Africa represents less than 1% of the total working capital finance afforded to small to medium size businesses, is because it is still a relatively unknown form of finance.
Debtors finance is used throughout the industries abroad. The total world domestic factoring now stands at a volume of some R7 trillion, constitutes 11% of all global borrowing, and is used in 62 countries.
Most of the commercial banks in South Africa offer this type of funding and there are other institutions that focus specifically on debtor finance.
What type of businesses makes use of this?
Businesses in a growth phase will require funding; so will those who need to carry debtors - but cannot afford it - and thirdly those businesses exposed to a sudden upswing of sales, should consider debtors financing.
It’s not easy for the typical SME to obtain debtor finance, due to the policies imposed by such financiers. First and foremost, the profile of the client (customer) forms the basis of the funding.
Then, if your client is also a SME, the possibility of raising capital on it, is remote. The profit history of the business will be scrutinized and the business must be in operation for a specific period of time.
As is the case with any type of financing, the small business owner should be very clear on what his options are, the pros and cons of this type of finance for his needs, and very importantly, the terms and conditions of the loan.
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