Debtor finance aims to release funds that are tied up in unpaid invoices. This helps your cash flow because the money is available as soon as the invoice is dispatched, rather than waiting for the client to pay. It can be a useful option to finance working capital and short term finance needs.
How debtor finance works
You “sell” your invoices to the lender (at a lower value than their worth). The lender then advances you an immediate loan of up to 80% of the invoice value.
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 the size of a company, professional reputation and payment history). 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.
There are two types of debtor finance: invoice discounting and factoring.
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 not confidential, and 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 financier takes over the administration of collecting monies:
- Invoicing: Every time you send an invoice to a customer, the factor records it and then sends out a statement to the customer as well as phoning them to make sure they are going to pay.
- Financing: The factor lends you up to 75% of the value of the invoice/s.
- Payment: When the customer pays the invoice, the factor pays you the remaining 25% minus the admin fee and the cost of the finance.
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 and you won't incur the costs associated with collecting debts. 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.
In this type of debtor finance, the lender doesn't take over the administration of the business' invoices, so it is a more confidential process. You are still in charge of making sure your invoice and debt collection systems work efficiently. 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 about 75% to 80% of the amount in the debtors’ book (outstanding invoices). The percentage lent varies from lender to lender and is linked to the total size of the debtor book and the customer rating and creditworthiness.
- Confidential invoice discounting: Your customers don't know that a finance provider is involved in the invoices, but this is an expensive option.
- Single invoice discounting: Sometimes you can get an advance for a once-off invoice or for all the invoices of one client. If you have a small business and don't have a lot of collateral, this could be a good option for you. It will only work if your customer is well established and trusted.
What debtor financiers look for:
- They may require a minimum monthly turnover of around R200 000.
- You must have reputable clients that are well known and have a good payment history.
If you do not wish your clients to know that you are raising finance through debtor finance, then select the invoice discounting option. In this case, lenders will ensure that you have good debt collection processes in place and that your history of managing your debtors is good.