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What is Debtor Finance and how does it work?

6 March 2020

According to the recent Xero Small Business Insights report, only 56% of Australian small businesses were cash flow positive in December 2019. February is the tightest month of the year for cash flow though, with just 47% of Australian small businesses having positive cash flow, on average, over the past five years. February is a tough month as invoices tend to be paid later than in other months, and it’s also a time when payments for stock to top up last year's sales are falling due.

If a business has more money going out than coming in, the business owner needs to plug the gap somehow to drive the business. This cash flow gap is ideally filled by drawing on the business’s cash reserves but if that's not possible, funds are often drawn from owners or business finance is used.

Of the business finance options, debtor finance (also known as invoice finance) is well suited to these tight cash flow periods where invoices are paid later than expected, as it allows business owners to access cash that’s locked up in those customer invoices.

What is debtor finance?

Debtor finance is a type of short-term business finance that lets business owners draw funds against unpaid invoices, and is repaid when the invoice is paid by the customer. Bringing forward this cash flow can be useful for covering operating expenses and working capital when cash flow is tight or as an ongoing source of finance.

With debtor finance, a business can typically draw up to 80% of their accounts receivable ledger and because the ledger is the main security for the loan, business owners don’t need to use real estate as security.

Invoice factoring vs invoice discounting

Within debtor finance, there are broadly two types of arrangements: invoice factoring and invoice discounting.

Invoice Factoring

Under an invoice factoring arrangement, a business sells its invoices to the factoring company at a discount to the full value of the invoices. When the invoice is paid by the customer, the full invoice value less the amount that was advanced and fees is returned to the business.

With invoice factoring, the responsibility of managing and collecting the invoices is then passed to the factoring company. In this scenario, the debtor is aware of the arrangement and makes payments directly to the provider.

A benefit of factoring invoices is that business owners can focus resources on running the business instead of chasing collections. The flip-side of this is that the factoring company will now be contacting your customers and they might not always deal with them in the same way you would.

Invoice Discounting

With an invoice discounting arrangement, customer invoices are not sold to the lender but are simply used as security for the loan. The business therefore retains responsibility for managing the accounts receivables ledger and collecting invoices so the business maintains control of the customer relationship.

Invoice discounting is generally undisclosed (or confidential) as the customer is not aware that an invoice discounting service is being used. 

Different types of debtor finance

Within invoice factoring and invoice discounting, there are a further two groups of debtor finance based on which invoices are used to access funds.

Full ledger debtor finance

Full ledger debtor finance is where the entire accounts receivable ledger is used to access finance. This maximises the amount of debtor finance that can be accessed as all of the accounts receivable can be drawn against.

Partial ledger debtor finance

As the name implies, partial ledger debtor finance is where less than all of the accounts receivables ledger is used to draw funds against. This can range from all of the ledger except for one customer, to the extreme of single invoice finance where only one invoice is financed. 

Often, debtor finance facilities operate as a line-of-credit and the available limit increases as invoices are raised and reduces when they are paid. 

How does debtor finance work?

As well as accelerating cash flows from invoices, debtor finance also provides certainty around timing as invoice payments are often unpredictable and take longer than hoped. Debtor finance is repaid when the customer invoices are paid so it can be a good way to access business finance while borrowing within the means of the business. Many businesses prefer this to the regular weekly payments of unsecured business loans that are taken regardless of the cash flow situation of the business.

Since customer invoices are security for debtor finance facilities, the lender will require an accurate and up-to-date view of the accounts receivable ledger. Some traditional lenders still require borrowers to upload invoices and accounts receivable ledgers which adds an administrative and bookkeeping burden for businesses.

Modern debtor finance providers like Skippr integrate with Xero, MYOB and Quickbooks so invoices can be viewed automatically and in real-time, saving time for business owners and their teams. This connected integration means both lender and borrower are clear on the amount available for finance and invoice and loan repayment are automatically reconciled. 

Connectivity with cloud accounting software platforms also solves a big pain point of traditional debtor finance - reconciling invoice payments to invoices. Skippr and some other modern debtor finance providers can automatically post journal entries to your accounting software which allows bookkeepers to reconcile invoice payments and loan repayments to bank transactions with a click of a button.

How much debtor finance can I get?

The amount you can borrow using debtor finance is linked to the value of invoices that are eligible for finance. Most lenders consider eligible invoices to be: for goods or services that have been completed; with customers of good credit quality; and are less than 90 days past the invoice issue date. Debtor finance providers advance around 80% of the value of eligible invoices. 

Am I eligible for debtor finance?

On top of having good quality invoices that are suitable for debtor finance, lenders will also assess the creditworthiness of your business. This will include a review of  revenues, profits, cash flow, existing debt levels and the time you have been in business. In the case of Skippr, we look for:

  • A valid ACN
  • More than 12 months in business
  • Invoices with other strong Australian businesses
  • Invoices are issued only after goods or services have been delivered
  • At least $1m annual revenue
  • Minimum of three customers
  • Integration with Xero, MYOB or Quickbooks

Is debtor finance right for my business?

It is generally best for businesses to match the loans with the way the funds will be used. If you are buying long-term equipment, an equipment loan that's repaid throughout the life of the equipment might be the best option. If you want finance to boost working capital to help your business grow, a debtor finance facility that releases cash from your unpaid invoices could be the answer.

Providing some form of security against business loans almost always makes it more cost effective for the borrower. Security can take the form of real estate, which a lot of business owners don't like to do, or it can be assets of the business like fixed assets or the accounts receivable ledger. Loans that are secured by assets will be cheaper than unsecured business loans as the lender is more comfortable that the  loan will be fully repaid.

With the increasing range of business finance options driven by the rise of fintech lenders, it's always a good idea to check in with your trusted adviser for some advice. They will have some experience in assessing financing options and be able to help you work out the best type of finance for you and your business.

Debtor finance that's easier than ever before

Business lenders that integrate with the popular cloud accounting platforms are making debtor finance easier and more accessible for Australian small businesses than ever before.

If you think that your business can benefit from Skippr's modern debtor finance facility and would like to find out more, please contact our team today on 1300 754 777.

Written by The Skippr Team