Debtor Finance – the Advantages and Disadvantages

2/13/2020

by Neil White, Guest Contributor

Whether you’re running a large company or a small business, cash flow problems can occur, and when they occur, they need to be addressed immediately, or your business can suffer. At that point, you are likely to look into taking out loans and other financing solutions, among which is also debtor financing. However, debtor financing has some very pronounced advantages and disadvantages, so it needs to be considered carefully.

If you’re looking to delve into debtor financing, here’s a short article that explains debtor financing and what can you expect out of this practice. Let’s take a look.

Two Types of Debtor Financing
Debtor financing concerns one thing but takes two different approaches to it. Namely, this type of financing is mostly revolved around invoices as a matter of payment to the company that is looking for a loan. Businesses usually issue such invoices when they provide a service or a product to a customer but have a 30- to 60-day payment arrangement. Such businesses can suffer from poor cash flow, especially if they're in their early stages, as they don't have access to their earnings right away. Debtor financing is then used to eliminate that problem and provide a good chunk of those finances immediately.

When it comes to the two approaches, the first is called invoice factoring. Invoice factoring involves the lender (a bank or a debtor finance specialist) paying up to 80% of each invoice's value to the business, while also handling tracking down debtors and collecting payment.

The second approach is called invoice discounting. In this approach, the lender pays up to 80% of the collected invoice value for a company, but the company retains the right to handle payment collection as they see fit. In both cases, the remaining 20% is paid after the debts are collected, and a fee is then subtracted for using the lender's services.

The Advantages and Disadvantages of Debtor Financing
The biggest advantages of debtor financing are the immediate availability of funds and the flexibility of the service. Having your earnings sunk immediately into your account means that you can eliminate your cash flow issues, pay your creditors and suppliers, and boost your company's growth. For this reason, debtor financing is extremely beneficial to companies that grow quickly and have good, reliable clients.

As for flexibility, each debtor financing loan is tailored to the company or the business in question. It also means that your cash will be available to you at any time, which is a great relief for businesses with seasonal fluctuations and small to medium-sized businesses that provide products and services for larger companies.

Another major advantage of debtor financing is that it doesn't require you to offer your assets, or the business' assets as security. However, some kind of security is required, and, in this case, you're required to offer your debtor ledger as security. This also allows you to offer your assets when considering other types of collateral loans.

Finally, using debtor financing is great for offering very customer-friendly payment options. Because you’re getting your money as soon as you sign the invoice, you don’t have to worry about getting paid in the near future, and you can focus on growing your business.

As for the cons, like all loans, debtor financing carries certain risks. Firstly, since you're putting no security down in case you can't repay the money you owe, the interest rates are also higher when compared to traditional loans. Besides, lenders are more reluctant to give you money through debtor financing, unless you can prove your customers are good on their word and will repay you as per your agreement. All in all, debtor financing is tailored more toward large companies that have a good track record, and small companies experiencing rapid growth and a spotless credit score.

Furthermore, while there are advantages and disadvantages to invoice factoring, one of the major drawbacks of this method of debtor financing is that it requires the lender to handle and receive payments, it comes with a certain stigma and might signal your customers you're approaching insolvency. This particular method needs to be handled with particular tact and care; otherwise, your brand image might take a major hit it cannot come back from.

Lastly, this kind of financing can have a negative impact on your credit score in the long run. Lenders are less likely to approve financial support to recurrent borrowers, so you need to weigh your options carefully, and use debtor financing sparingly.

Conclusion
All in all, debtor financing can be a bit of a double-edged sword, especially if not approached carefully. On one hand, the immediate availability of funds is certain to improve your cash flow dramatically and spur your company’s growth, but, on the other, you might have to pay fees with which you’re not entirely comfortable, and, if things go awry, you can lose control of your ledger. In the end, this particular form of financing is tailored more toward specific businesses and industries, so your business might not even have the opportunity of using it, and will instead have to go through usual channels. However, through this little article, you now at least know what you can expect from debtor financing, and can weigh the pros and cons against your business to determine if it’s the right choice for you.

About the author:

Neil White is an HR Specialist and business journalist from Sydney, Australia. Having worked in companies all over Australia for almost 10 years, he likes to consider himself as a business and human resources expert. Huge soccer fan.

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