Debtor Financing: A Great Way To Finance Your SME In 2015

Many small and medium sized businesses (SMEs) experience ongoing cash flow difficulties which are a major obstacle to growth. Without adequate funding, it is impossible to build a platform to competitively supply the market and become a sustainable enterprise.

What can debtor financing do for you?

In short, you convert your sales invoices to cash.  Banks and certain finance providers will pay a business a percentage of the value of its invoice upon presentation of the invoice and proof of supply – this is usually 75% to 80% of the invoice value although some institutions advance more than this. If the business normally collects its debtors in, say, sixty days, it now receives the specified percentage on the date of invoice or a day or so thereafter. Effectively, the business either solves, or substantially improves, its liquidity position.

This increased flexibility means the entity can finance increased sales. In addition it can drive down costs by taking advantage of settlement discounts offered by suppliers.  

In most instances, this gives the SME the leverage to become a sustainable business. 

How does it work?

In practice there are several different models for debtor financing. As costs vary depending on the model, seek advice from your accountant.

The main procedures usually followed are:
  • The financial institution will do an audit of the debtors’ books, stock and internal controls, 

  • They will assess how sustainable the business is,

  • The institution will require some form of security – usually a cession of debtors and sureties from the owners, 

  • When the invoice is paid by the customer, the amount originally advanced by the finance institution is refunded to it.  With factoring, the remaining retention percentage is then refunded to you (i.e. the amount of the invoice less the 75% or 80% advance).

Types of debtor financing

There are two models used, one is known as invoice discounting and the other factoring.

With invoice discounting, you keep control of your debtors and operationally there is little change to your business. Thus, you collect your debtors and, apart from the cash inflow from invoice discounting, there is little change in your business. 

In factoring, the full debtor's function is now managed by the factoring institution you contract with. They will collect your debt and assist in managing your credit policies.

Some businesses prefer invoice discounting as there is no visible change to the business from the customers’ perspective and thus they will not be aware the organisation has cash flow difficulties. Also, many businesses actively use their customers as a marketing tool and as a tool to grow their business e.g. giving a discount to certain customers or allowing them an extra 30 days to pay for a large order. This will be more difficult to do if you use factoring.

Your choice also depends on your particular circumstances - many businesses find that factoring suits them as they get a professional debtor administration service with the ability to distance themselves from any robust collection action required against slow-paying debtors.

What are the costs?   

With invoice discounting, there is a monthly administration fee (usually around R10,000 per month) – this fee covers a monthly audit by the financial institution of invoices, credit notes and monies paid by debtors. 

With factoring there is a factoring fee per invoice (generally between 0,5% and 2,5% but check before you commit).

In both cases, interest is charged on the monies advanced by the institutions.

As a rule of thumb it is cheaper to use factoring up to R500,000 monthly sales and thereafter invoice discounting gets progressively cheaper, but there may be other factors at play so ask your accountant for advice on your particular circumstances.

Bear in mind also that if you choose factoring and then later decide to discontinue debtor financing, you lose the factor’s assistance in collecting debts and so will face the practical challenge, disruption and cost of having to take the full debtors’ function back into your business.  

The bottom line is that as these types of facilities can be the boost your business needs to achieve sustainability, the cost is not excessive.
The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.