How Does Debtor Finance Work and What Is It?

By Ram - Dec 27 2023

Every business growth is dependent on having a positive cash flow. Making more sales is one of the ways to maintain a positive cash flow and working capital, but only if your clients are making the payments promptly. If not, you may experience cash flow finance challenges even when your sales are through the roof as you wait for your invoices to clear.

Most businesses turn to short-term loans to bridge the gap when this happens. In the long run, these loans might leave the business in more trouble because it has to make monthly payments, which digs further into its working capital.

Businesses can use better and more economically practical methods to improve their cash flow without falling deeper into debt. One of those ways is debtor finance.

What is Debtor Finance?

Debtor finance is a way businesses release capital tied up in outstanding invoices. It enables you to use your accounts receivable to access fast funding and maintain cash flow.

When businesses raise an invoice after providing goods or services to their clients, they will typically offer payments of up to 90 days for the invoice to be cleared. The larger the invoice value, sometimes the longer the payment terms.

When using debtor finance services, businesses can receive an advance of up to 80% of the value of the unpaid invoice upfront. This advance can be used for various business activities, including paying suppliers, replenishing stock, or making payroll. Businesses can also use the lump sum for their expansion endeavours.

This type of arrangement can be a lifeline for growing businesses and businesses with extended cash cycles. Instead of waiting for your customers to pay, you can release the capital tied up in your sales invoices and reinvest in your business. Simply put, debtor finance allows you to access the money you’ve earned faster without waiting for the full period indicated on the payment terms or for your clients to pay.

This method of business funding is more flexible than business loans or an overdraft and doesn’t sink the business into a debt cycle, so you don’t have to worry about making monthly payments. Also, traditional business finance methods are limited to the equity value of your home or a high-value asset used as collateral, which can be limiting for some businesses. With debtor finance, all you need are copies of the unpaid invoices. Your limit is set by the number and value of the invoices you raise. The more sales you make, the more credit you can access.

How Does Debtor Finance Work?

Debtor finance has been around for centuries. But for most businesses, it’s still a new concept they don’t fully understand. Luckily, understanding how debtor finance works is simple and straightforward..

Debtor finance uses your unpaid sales invoices as collateral to provide your business with immediate funding.

You simply send the invoice to the finance company, who will provide you with an advance of up to 80% of the invoice value. Once the customer clears the invoice, you receive the balance minus any financing fees owed to the finance company.

To fully understand how debtor finance works, you should know there are two types of debtor finance;

Debt Factoring

Debt factoring is a more suitable option for small or budding businesses trying to overcome their cash flow gaps using their accounts receivables.

The level of responsibility for collecting invoices and account management is shared between the factoring company and client as agreed upon facility setup. With debt factoring, you can also get up to 80% of the invoice value within 24 hours.

Here’s a breakdown of how debt factoring works;

  1. You provide a service or deliver goods to your clients and invoice them as usual.
  2. You send the invoice to the debt factoring company
  3. The company verifies the invoice and sends you up to 80% of the invoice value
  4. Your customer pays the factoring company when the invoice is due
  5. The company deducts their charges and sends you the balance to your account.

With debt factoring, payments are made in two instalments. The first one is when you submit the invoice, and the second is when the customer pays the invoice.

Invoice discounting

The second type of debtor financing is invoice discounting. It is generally used by larger companies with a dedicated accounts and collections department.

With invoice financing, the debtor finance company can provide up to 80% of the invoice value upfront, with the remaining balance released when the customer completes payment, less any fees for the services.

Unlike debt factoring, where the customers are aware of the facility in invoice discounting, your business is responsible for collecting the payment of the invoice.

Here is a look at how invoice discounting works;

  1. You deliver goods or services and invoice your customer as usual
  2. You submit a copy of the invoice to the finance company
  3. You receive an advance of up to 80% of the invoice value upfront after verification and other due diligence steps
  4. You collect the payment from your customer
  5. Customer payments are remitted to a designated bank account under the ultimate control of the invoice discounter.

Debor financing options, such as debt factoring and invoice discounting, provide businesses with regular funding to fuel their growth plans without taking out expensive loans that might hurt the business’s cash flow even further down the line.

The fees incurred with debtor factoring and invoice discounting depend on the value of your invoices, the duration of the funding facility, the credit scores of your customers and the type of debt finance.

As a general rule of thumb, debt factoring costs more than discounting because of the collection and account management services included.

Who Can Benefit from Debtor Finance?

Debtor finance is a viable option for any business that offers extended payment terms to customers. It provides startups and even more established businesses with a stable credit source, and the funds received can be used for various functions, including paying bills, negotiating early payment discounts with suppliers and offering net terms to entice new customers.

Any business needs to align itself with a funding option that serves its long-term goals and growth plans. With debtor financing, you get to use the money tied up in your debtor’s ledger to fuel the growth of the business as opposed to taking on new loans, making this an effective funding solution.

Is Debtor Finance Right for My Business?

Debtor finance might be an excellent financing solution for some businesses but not for others. Whether it’s the right one for your business depends on several unique circumstances and the reason for the funding.

It might not be an ideal funding solution for businesses mainly dealing in cash. However, if you sell on credit terms then it works perfectly for businesses. It can even assist a business with bad credit or can’t secure loans. In fact, some businesses use this type of funding to mend their credit records.

Closing Remarks

A positive cash flow is a critical factor in every successful business. However, in many cases, business plans don’t go as planned, and the business might find itself with a less-than-stellar cash flow that might threaten its operations. With debtor finance, the business gets a chance to leverage its unpaid invoices to get funding.

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