Did you know that you can get cash upfront for your invoices?
In fact, unlocking the cashflow in your invoices has never been easier due to the rise of fast, online debtor financing services. But are these solutions right for your business? Let’s look at what debtor financing is, how it works and the costs associated with using this financial product to increase your working capital.
How does debtor financing work?
Debtor financing (aka receivables financing) is all about getting cash upfront for your invoices rather than having to wait for your customers to pay (which is often right at the end of the 30-day payment period).
A debtor financing product will pay you a percentage (e.g. 80%) of the invoice value upfront, and pay you the balance when the customer pays 30 days later (minus their fee for providing the money earlier).
This is the general structure of debtor/receivables financing. Invoice discounting and factoring are different types of debtor financing.
With invoice discounting, you continue to manage the collection of payment from the invoiced customer. The lender trusts you to chase down the invoice and make sure it gets paid.
- You will incur the costs of follow-up and administration
- The service fee will typically be lower than factoring because you are doing the leg-work
- Given that you continue to manage collection, the customer often doesn’t need to know that you have a debtor financing arrangement.*
- As this involves a degree of trust on the part of the lender in your payment collection processes, the lender is more likely to offer this solution to established businesses with large turnover from trusted payors (i.e. large companies).
*This will depend on the terms of the agreement with the lender, but if maintaining your relationship with the customer is important then this may be preferable.
With factoring, the lender takes over payment collection on any invoice on which they have advanced you funds. This means that they may call the customer to request payment when the payment deadline comes up, and pursue any further collection processes.
In this case:
- You have essentially outsourced your collection process, which can be great for small businesses that don’t have the resources to chase payments effectively
- As the customer will be receiving correspondence from the lender, they will know that you’ve got an invoice financing arrangement in place
- Factoring service fees are often more expensive than discounting because the lender has employed people to make sure the invoice is paid by your customers
- Factoring requirements are often lower than invoice discounting and are available to smaller businesses with lower turnover. This is because the lender is confident that payment will be made, given that they are handling collection.
When would invoice discounting or factoring be good for my business?
These debtor financing products are typically used to help with working capital management for B2B companies with longer payment terms.
If you find that you are often short on cash because you have to pay your suppliers before your customers pay you, then debtor financing can give you quick access to the capital that you need to run your business.
These products can offer some strategic benefits, such as:
If you believe that you can win more business by offering longer payment terms to your customers, then your uplift in sales might be much more valuable than the fees that you incur using debtor financing. This requires careful business planning to execute.
You may be able to recoup some of the cost of the facility by removing any early payment discounts that you were giving customers before you took out the facility (given that you no longer need to incentivise them to pay quickly). Having an invoice financing product in place can demonstrate strong financial management to lenders or investors.
How much does it cost?
It’s important to fully understand the cost structure of these products before you use them. Rather than quoting an interest rate per annum, debtor financing products typically have:
A service fee, which is a flat % of the total invoice value that they will retain as their fee (typically 1-3% on the total value of a 30-day invoice) An interest rate on the actual amounts advanced (e.g. 10% per annum which would be 0.82% for a 30-day invoice)
If you add these and convert them to annual rates, the rates can seem quite high (12 - 40% per annum), but if the facility means that you can sell more products and services with less risk, it can make it worthwhile.
Let’s run through an example
Say, for example, the invoice that you need to be financed is $100,000, payable by your customer in 30-days.
The lender is asking for a 1.5% service fee and a 10% per annum interest rate on advanced funds.
The lender pays you 80% of the invoice value, which means you receive $80,000 today.
In 30 days, the customer pays the lender $100,000.
The lender keeps their 1.5% service fee on the $100,000 ($1,500), as well as a 0.82% (30-days of 10% per annum) interest rate on the $80,000 they advanced to you ($658). In total, the lender retains $2,158 in fees.
In practice, this means that you paid $2,158 in fees to get $80,000 today rather than in 30 days, as well having someone else manage collection. You paid 2.7% for 30 days or an annualised interest rate of around 33%.
While this is a lot, particularly compared to a secured term loan, it can be worth it. As with any financial product, weigh up the pros and cons, and get a clear sense of the value you stand to create.
- Are you solving a business-critical cashflow shortage that saves you from liquidation?
- Are you enabling new sales by getting more inventory through? How many sales, at what margin? Would they have waited and bought anyway after 30 days? All else equal, profit on additional sales you wouldn’t have made otherwise should exceed the interest you paid.
- Are you saving yourself hours of chasing your customer for payment? Put a value on your time to convert these hours into a $ value (if you offer a service, consider using your charge-out rate). Include this in your cost/benefit analysis.
- Could you have taken alternative finance at a lower rate to address the working capital shortfall? If you could get the benefits above using a business credit card, overdraft or lower-rate facility, you will probably save money.
So what are the alternatives?
Let’s keep running with our $80,000 example. How else could you have accessed this capital earlier than the 30-day mark? The obvious options are your business credit card or overdraft account, where the rates on drawn amounts are typically lower.
However, $80,000 is quite a large amount and these options may not be suitable which is why a lot of B2B companies end up using debtor financing at some point.
If the working capital requirement is a one-off, you could potentially take out a regular loan or line of credit to cover it. The rate will probably be lower, particularly if it is secured. This could save you money but may lock you into a longer-term loan, whereas debtor financing satisfies a short-term cash problem.
These types of loans will also typically take much longer to arrange and finance. With debtor financing, funding can often be arranged within a few days, and the facility can be accessed as needed for individual invoices if the lender offers “spot factoring”. Speed and flexibility is a strong drawcard that debtor financing has over a traditional loan in circumstances where your overdraft or business credit card can’t cover your working capital need.
Is it right for my business?
Key things to keep in mind when assessing whether debtor financing adds value to your business:
- It is a short-term, recurring solution — if you have a long-term cash need, you will probably save money with a lower-rate, longer-term loan.
- Rates are comparatively high, given that you will most likely get paid by your customer anyway. Your overdraft or credit card will almost certainly be cheaper if the limits are enough to cover your working capital need.
- Think about the time saved on collections — as a small business ourselves, we know that time is your most important resource.
Jacob leads the Working Capital team at Valiant. He is the go to guru for assisting small business owners with their everyday business finance needs.