Explaining What Is Debtor Finance

RandyYoumans

The average business commercial payment time frame is currently around 60 days, a statistic which has steadily increased over recent years. A business trading on credit terms with other businesses, will over time accumulate a substantial asset on its balance sheet called Accounts Receivable, or Trade Debtors.

Debtor Finance is a broad description which describes a type of finance which uses trade Receivables as security for a cash advance. In technical terms there are a variety of legal models for debtor finance. In some situations it is structured simply as a loan, with the Receivables asset acting as security, much like a home mortgage.

On the other hand, factoring usually involves legal ownership of the debts passing to the financier, possibly on an undisclosed basis – i.e. the debtor is not informed – or more often fully disclosed where the debtor is made aware of the financing arrangement.

When debtor finance is in the form of a debt factoring arrangement, the cash advances available can be flexibly adjusted according to a percentage of debtor sales which provides a high level of convenience for a business which is expanding, and needing more cash to do so.

Security Requirements of Debtor Finance

All debtor finance arrangements carry some security requirements, firstly directly over the Receivables, but also possibly (less desirable from the borrower’s point of view ) supported by collateral assets and/or personal guarantees.

As with other forms of credit which are linked to the value of the underlying security the amount borrowed or financed will depend on the asset values. Typically debtor finance funding is permitted for about 70% to 90% of the value of the debtor invoices.

Advances and Cash Flows

A factoring arrangement which involves the financing of the entire debtors ledger, can effectively operate just like an overdraft. This means that within the overall financing limits, and taking into to account such factors as bad debts when they occur, the borrower can effectively draw and repay any amount at any time.

Smaller financing arrangements which include Invoice Finance or Invoice Discounting arrangements will generally split the financing into two cash flow lumps:

  • The first lump is the advance, for 70% to 90% of the invoice value
  • The second lump is the balance, from which the financiers recovers fees.

Each financing method has its pros and cons. Financing the entire debtors ledger will usually involve some contractual commitments for a period of time, at least 6 months, often a year or more. Invoice finance on the other is generally shorter term, and may not require a fixed term commitment. Invoice finance be very flexible when used on an ad hoc basis, helping to keep costs down, but closer monitoring of actual cash flows would normally be necessary.

When Is Debtor Finance The Best Option?

Debtor finance is most useful for a business which has relatively long cash conversion period, when compared to the cost of its major supplies. This is best explained by way of example: Simplistically if a business has to pay all its bills in an average of, say 21 days, yet the settlement terms of most of its customers are 45 days or more, then expanding the business will always absorb more cash than is available from the business in the short term.

This kind of cash flow stress most often arises in manufacturing companies, wholesalers and labor hire companies; in effect any business where the cost of sales is made up to a large extent by labor costs, and/or inventory.

If other sources of finance are not available, or are more expensive, then reaching into the company’s balance sheet for a debtor financing arrangement can release cash to the next project or job, while valued customers can still take advantage of their normal payment terms.