• Wallace Fan

When debtor met finance

Updated: Jun 25, 2019

The difference between debtor finance, factoring, receivables financing and invoice financing

Recently, a few clients asked me about the difference between debtor finance, factoring, receivables financing and invoice financing. I sensed some misconceptions in the market place on what they are and how they should be evaluated. I hope the following could be of use.

They are in fact very similar. Despite the various names financiers put to their offerings, they are all about leveraging your trade debtors, who have been provided with goods or services but have not yet paid in full. In short, financiers fund a pre-agreed ratio (i.e., 80%) to every invoice amount presented. Then, when the invoice is paid, the proceeds will first go to repay the financier plus his fees and interests and then the balance goes to the borrower.

Regard them all as forms of “working capital” funding facilities, targeted at helping you fund the timing difference between outlaying capital to secure your goods and collecting your sales proceeds.

They are also different in their own subtle ways. Putting aside the various names and whether the financier uses online versus paper drawdown methods, the key difference is “on” versus “off” balance sheet, or who retains the ultimate ownership (or risks) of the trade debtor. This makes all the difference in managing your business.

With off-balance sheet, you effectively sell your outstanding receivables at a discount (usually up to 80-85%). The financier will take control of chasing your customers for payments, which will be paid into a controlled account by the financier. In most cases, the financier will require you to disclose such arrangement to your customers before implementing the facility. It carries the risk of disrupting your customer relationships. The flip side is that someone is helping you collect—view it as an outsourced receivables collector.

On the other hand, on-balance sheet debtor financing means a current liabilities facility is created (again, at a discount) and secured by the trade receivables. Drawdown and repay mechanism will be similar to the off-balance sheet type. However, subject to negotiation, this could be structured as “undisclosed” to your customers and you may keep the financier out of your customer relationships.

When to use this financing? Typically, you would consider this form of financing when your business has a good churn of inventory or large trade debtors on 60 to 90 days terms. Debtor financing then could help convert the outstanding receivables to cash and fund your next purchase of inventory for sales growth. In the majority of cases, this form of financing is used by small to medium businesses and, to some extent, is the funding of last resort in turnaround situations.

One can imagine the onerous conditions and fees in those situations. From the financiers’ perspective, they, like business owners, prefer good credit or blue-chip customers who are unlikely to default on payments due to an inability to pay. Also, financiers prefer businesses (borrowers) who have good performance track records, hence reducing the probability of returns, warranty, set-off, etc.

Although, traditionally, financiers prefer lending to businesses that sell goods to those that sell services, many financiers nowadays are open to both as long as they can be easily identified and quantified. An example of an ideal borrower could be a business selling toilet paper to Commonwealth Bank. Both discounting and borrowing rates would be lower comparing to a business selling computer system integration time to a biotechnology start up.

Is this for mid-to-large corporates? Yes, the concept can be derived into “structured” debtor (or contract) monetisation where an established company may arbitrage the difference in its credit versus its customers’ credit and therefore, increase borrowing to a higher level and achieve more competitive pricing that the company normally could achieve. For example, it could be used by a company that runs its business according to a government contract or that holds multiple long-term contracts with blue-chip clients. Of course, the devil is in the details of the contracts. This is going into the realm of bespoke funding solutions: a discussion for another day.

Recent market developments. Many banks closed down their debtor/invoice financing businesses during the GFC as they faced comparatively higher risks than with their vanilla-lending businesses. However, many private financiers have also since sprung up in the marketplace and have taken over the financing roles in SME segment and in turnaround situations. They all offer slightly different products, hence the confusion of names.

At the upper end of the lending markets, structured financiers have been looking into sectors where a similarity of “tolling” feature exists, so that monetisation can be structured.

Lastly, everyone should be aware that debtor financing is not the only solution for financing working capital. Throughout the supply chain, there are also suppliers, inventory and payment systems to be explored and improved.

A holistic approach is the key. I would be pleased to receive your feedback on how you finance your working capital.

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