felt than in business lending, with the market remaining extremely constricted. Not only is it difficult to secure funding through traditional funding lines as financial institutions tighten policies and lending criteria, but for those who are able to secure an overdraft, the terms on which money is lent are unfavourable when compared with those in the days prior to the GFC. These changes in market conditions have, however, opened the door for other non-traditional lending facilities as businesses seek viable alternatives. This is evidenced by the continued growth of the debtor finance sector.
The most recent quarterly index for the Institute for Factors and Discounters of Australia and New Zealand (IFD), which measures total industry turnover, showed debtor finance offered to Australian businesses over the past 12 months totalled A$61.8 billion. This represents growth of approximately four per cent for the year, compared with flat growth in total business credit in the same period (according to RBA figures).
While we’re witnessing the continued acceptance of debtor finance as Australian business continues to experience a challenging cash flow environment, the industry could still be considered to be in its infancy when compared with overseas markets where debtor finance is far more commonplace. It’s estimated that in the United Kingdom and Europe, for example, approximately 20 per cent of businesses use debtor finance in some form or another. In Australia, however, it’s more in the order of five per cent, so the market here is far from mature. We expect to see debtor finance grow in popularity as SMEs seek to leverage their debtors to enhance their cash flow position, the lifeblood of every business.
How does debtor finance work?
One possible reason why the debtor finance market in Australia is lagging other parts of the developed world is because it’s often not well understood. Further complicating matters, debtor finance is known by many different names, including receivables finance, invoice financing, factoring and cash flow finance – the list goes on.
Regardless of the name ascribed, debtor finance in reality is a simple and straightforward finance facility, with it working as either factoring or discounting.
Factoring and discounting are two options for businesses to improve their cash flow. Both of these financial arrangements are primarily secured against the unpaid invoices of a business. Under both facilities a company sells its unpaid invoices to a provider for immediate access to cash, but under the factoring arrangement the provider additionally manages the company’s sales ledger and collection of accounts. Therefore, under a factoring arrangement the debtor makes payments directly to the provider.
Under discounting, the debtor makes payments to the company, as per usual, but as the debt is owned by the provider, the company manages the collection process and then passes the cash collected to the provider.
Key benefits
One of the attractions of debtor finance is that it’s a self-liquidating facility, meaning that the company isn’t taking on additional debt per se but rather receiving an advance on money that is already owed to it. The goods or services have already been provided, and while the facility needs to be repaid, this should take care of itself as a matter of course as the company’s debtors settle their invoices.
One of the key benefits of debtor finance facilities is that, unlike overdrafts, they do not generally require real estate security. This is particularly pertinent in the current environment of falling real estate values where the credit extended under a traditional overdraft arrangement may be limited so that it remains in line with the value of the property securing the overdraft.
The role of debtor finance
Two problems conspire to constrain the growth of today’s businesses. The first is late-paying customers, which can stretch the liquidity of a business to its limits and lead to the imposition of additional interest charges. The second is hard-to-secure overdrafts which often provide an inflexible form of finance unable to respond to fluctuations in business activity.
Debtor finance provides a financial solution to address these problems and enables businesses to survive cash flow crises and realise their growth potential. It’s true that many see debtor finance as a tool to overcome short-term cash flow constraints which may impact a company’s survival. There’s a growing number of companies engaging it more strategically, however, by utilising the enhanced cash flow position to grow their business through employing more staff, for capital expenditure, or to execute acquisition strategies.
While there are many advantages for companies using debtor finance, according to our research businesses state the three key benefits to be:
- freeing of cash within 48 hours (usually between 75-90 per cent of the value of an invoice) allowing the business to accelerate growth
- the ability to utilise the cash flow to obtain early settlement discounts from suppliers/creditors (up to five per cent)
- factoring reduces management time spent on chasing slow payers, allowing business managers to concentrate on areas more appropriate to their responsibilities, such as driving new volume.
Suitable for many, but not for all
While an increasing number of Australian businesses are engaging debtor finance to support growth strategies, it isn’t suitable for all organisations. Circumstances where debtor finance may not be appropriate for a company include instances where:
- invoices are payable on a progress basis (common in the construction industry)
- invoices arise from a retail or consumer transaction (debtor finance is restricted to business-to-business debts only)
- trading terms exceed 60-90 days from delivery month end
- the debtor has, or may have, a right of set-off (for example, where the debtor is also a creditor)
- a single or small number of debtors represent a very large percentage of the debtor’s ledger (this is called high concentration and is a business risk in case of disputed debt or debtor failure).
Notwithstanding the fact that some businesses are not suitable for debtor finance facilities, the ongoing volatility and uncertainty in the economy heightens the importance for all organisations to have sound credit lines in place. With funding through traditional overdraft facilities remaining difficult to access, a growing number of businesses are seeking alternatives. The debtor finance market is benefiting from this shift in how businesses think about credit, with an increasing number turning to discounting and factoring arrangements to improve cash flow and pursue growth strategies.
