What Is Debtor Finance?

To the uninitiated, learning what is Debtor Finance requires a basic understanding of the business balance sheet. The balance sheet of a business which trades on credit terms with its customers will list an asset, which is the total value of customer invoices unpaid at a point in time, usually described as Trade Debtors or Receivables.

Debtor Finance is a general term which refers to the practice of raising finance by using a business's unpaid receivables as security. It is a form of asset-based lending, the "asset" being the business debtors.

In reality there are a number of debtor finance formats, ranging from a simple loan agreement using Receivables as security for the loan, to factoring arrangements which enable the funding of a percentage of credit sales on an ongoing basis, and is utilised much as a bank overdraft.

Although the effect is similar, i.e. Receivables value utilised to support a cash flow advance, the legal implications and operational requirements of various Debtor Finance arrangements are significantly different.

For a business wanting to go down that funding path, it is very important to get a clear understanding of what is the Debtor Finance type and structure being undertaken.

Security Requirements of Debtor Finance

In practice there is a wide variation of security requirements from the various debtor financiers. Some may require property security, much like a bank loan; almost all financiers will require personal guarantees of the directors.

But usually the asset security for a debtor finance facility will be met, and limited to, the value of the Receivables ledger, and this is the major advantage debtor finance has over other forms of secured borrowing.

For added flexibility which is especially useful for growing businesses, where the debtor finance takes the form of a factoring agreement, the financed amount available is generally geared to a percentage of debtor sales.

The advantage of this is that as sales increase, so does the amount of finance available, enabling a business to expand much more quickly that it would otherwise be able to.

What is Debtor Finance Borrowing Limit?

As with other forms of asset-based lending, there is a limit on the amount which can be borrowed which is based on the asset security.

Typically debtor finance arrangements allow for a cash drawing of between 70% to 90% of the debtor invoice value.

This means that the cash flow associated with debtor invoices is split into two parts:

An Advance of (say) 70% of the invoice value, which is paid or drawn when the legal requirements for the invoice validity have been met. This is generally after the goods or services have been delivered, and some form of acknowledgement of the debt has been obtained, or legally deemed. The timing of this advance is therefore conveniently almost immediate.
The balance of the invoice value, usually referred to as the "retention" amount is available when the customer has paid the invoice, typically in accordance with the agreed credit terms, for example 30, 45 or 60 days. Of course the financiers fees must be subtracted from any amounts which the business borrower can receive.

What Is Debtor Finance Suitability?

Clearly what is debtor finance ideal conditions will not be met by all businesses.

A business which doesn't trade on credit terms with other good-credit quality businesses on normal credit terms will not be able to take advantage of a debtor financing arrangement.

This excludes businesses supplying consumer goods and services. Debtor Finance is also much more difficult to arrange for businesses which receive their cash flow through conditional contractual instalments, such as in the building industry.

Debtor finance is most likely advantageous for a business which has a high percentage of its costs payable in a shorter period than that given to customers to pay, and which therefore has an inherent cash flow gap in its operations.

So for example businesses with relatively high inventory, or with a high labour cost in its cost of goods sold will get the most advantage; the acceleration of cash collections enables the bills to be paid on time.