Debtor finance aims to release funds (which improves cash flow) that are tied up in unpaid invoices. (It can be a useful option to finance short-term working capital needs.)
How debtor finance works
You “sell” your invoices to the lender (at a lower value than they're worth). The lender then advances you an immediate loan of up to 80% of the invoice value. The lender will pay you the rest when your client eventually settles your bill. However, this comes at a cost.
It is really important to understand that invoices are categorised by the length of time that the debt is outstanding AND by the quality of the client (this is done by size of company and professional standing). So invoices that are 90 or 120 days old may have little to no value for a debtor financier as they are considered high risk and might need to be written off. They are also not interested in invoices for individual people and very small, unknown companies. Some debtor financiers will only work with companies that have a minimum invoice book of R200 000 per month, however, there are small debtor financiers who are prepared to consider debtor financing on a case by case basis.
Factoring and Invoice Discounting
When exploring debtor finance you will come across these two terms. They refer to the different ways of managing the process of collecting debts: Your clients could be informed that their money will be collected by the debtor financier (factoring) or you might prefer that your clients are not made aware of your debtor finance arrangements (invoice discounting). The only real difference between factoring and invoice discounting is that factoring is confidential – that is your client will be aware of this process. Invoice discounting on the other hand can be confidential (but doesn't always have to be). In many cases, particularly in articles written for the man in the street, the two terms are interchangeable.
How factoring works
In this case the debtor lender takes over the administration of collecting monies as shown in the diagram below.
You carry the risk if your customer doesn't pay the invoice at all! The factor will start charging you a higher interest rate if your customer doesn't pay on time, for instance taking over 60 days to settle the invoice. After 90 days, the factor will want to be paid in full! The good news is that debtor financiers usually have good systems for checking creditworthiness - and will check out any new clients you get, thereby reducing the risk of non-payment.
The cost of factoring
There are two types of fees involved in factoring:
A prime-linked interest rate: You get charged an interest rate on the money you borrow (usually only for the portion of the money that you use).
Administration fee: This is worked out as a percentage of the value of the invoice - but with a minimum monthly fee of approximately R7 500.
This might seem like a steep admin fee, but remember that you will have cash on hand to pay your suppliers early. This means you can get, or ask for, a discount for settling your supplier invoices sooner than required. Factoring can be an option to explore if you generate a high monthly turnover and don’t have the administrative systems in place to manage debtors. If you have negotiated good supplier discounts for early payments, then you benefit even more.
In this type of debtor finance, the lender doesn't take over the administration of the business' invoices (which happens in factoring). You are still in charge of making sure your invoice system is working efficiently—your invoices go out, statements are sent, invoices are paid on time, etc. However, most debtor financiers will insist that a separate bank account is opened to collect the payments that are being used for invoice discounting. This way they can monitor the collection of payments and will deduct their fees from this account.
The lender will lend you up to 80% of the amount in the debtors’ book (invoices). The percentage lent varies from financier to financier and is often linked to the total size of the invoice book.