Many SME businesses get caught in a Cash Trap because they don’t understand how Working Capital functions, and how Working Capital shortages can create a highly stressful Cash Gap in their business. (Read more about how the Cash Trap hobbles SMEs here.)
There are three main Working Capital tools that I use to help my SME customers defeat the Cash Flow pressures they face from unrecognised business Cash Gaps. These are:
- Invoice (Debtor) Finance
- Trade Finance
- Unsecured Business Loans
This post explains Tool #1 – Invoice Finance (often also called Debtor Finance). Future posts will cover Trade Finance and Unsecured Loans.
So here we go…
What IS Invoice Finance?
Invoice (Debtor) Finance is a tool that you can use to secure finance based on your business balance sheet (not your assets) using your unpaid customer invoices (Debtors) as security.
Why do you need invoice finance?
Fundamentally, the credit terms you give your customers are a loan to them, lending the value of your product or service for 30/45/60 days (or even longer).
This means that your business pays for inputs weeks and months in advance of when you GET paid. That’s good for your customers – but it’s REALLY bad for your business cash flow.
Ideally, your pricing includes an allowance for this loan – so it’s not interest-free. However – even if it does cover some of your cost – it DOESN’T solve the timing problems that can put your SME deep in a Cash Gap hole.
That’s where group of working capital products called Debtor Finance come in. Debtor Finance is a way of getting early access to money you’re going to be paid in the future. So it’s not a volatile, risky, uncertain product – it’s just a way to get the money you’ll eventually be paid – NOW.
Debtor (invoice) finance been around in big business for decades – but today FinTech makes it super-accessible to a whole range of SMEs – and without huge administration overheads.
A “Claytons” loan – because it’s not your average loan
In a way, Debtor Finance isn’t really “borrowing” – in the sense of borrowing “new money we haven’t earned”. It’s simply bringing money forward that you’re already owed.
So it’s quite different to a traditional “loan” situation. It’s still a credit product, so you do have to meet qualifying criteria. However, what you’re really doing is getting paid for your existing invoices early. And the security is your customer’s credit ratings, not yours. So how big you are and how long you’ve operated isn’t of that much interest to the provider.
In many industries, a SME’s customers often have much better credit ratings than the SME itself – so this makes them a good source of debtor finance security.
Your cash gap starts to shrink
So invoice finance can solve a big part of your cash flow problem, because it brings the majority of your funds into your business -immediately.
That typically eliminates a lot of cash flow headaches and stresses within your business.
There are additional benefits too – because once a business has liquidity (in other words – additional cash available to spend) it has a lot more room to trade and manoeuvre and take advantage of opportunities.
You can add in Debtor Insurance for extra risk reduction
Debtor insurance – also called Trade Credit insurance – insures your accounts receivable and protects your business from unpaid debts caused by customer bankruptcy and defaults. It’s a useful extra protection to Debtor Finance in a world where insolvencies are at a record level.
An overview of Debtor Finance
Basically, when you have Debtor Finance, you initially invoice your customer for a given amount, then provide a copy of that invoice to your debtor funder.
The debtor funder will provide you with 80% of the value of that invoice immediately. So – instead of waiting for 30, 45 or even 60 days to be paid – you’re able to get 80% of your money back into your bank account at once.
When the customer pays that invoice, you will receive the balance of the invoice, which is the other 20% LESS the fees and charges that are involved.
So that will be the interest cost – or a small percentage of the invoice and a handling fee – that is charged to the invoice.
It IS an extra costs – BUT you’ve typically had 80% of the invoice payment from the day you invoiced – to use in your business to grow your business.
For the majority of SMEs, that’s a pretty good return (especially where they can build the cost into their pricing going forward).
Costs and returns of Debtor Finance
Debtor Finance essentially brings your own funds forward, so you’re much less exposed to market fluctuations.
It has a lower overall cost and an easier-to-meet credit criteria – because when you borrow you’re using the invoice that you’ve issued for delivery of goods as security, plus the quality of your customer.
For example, if you’re a very small business and your principal customer is a blue chip (someone like BHP) then it doesn’t really matter what your own credit record looks like – because lenders know that BHP are going to pay you the money provided the goods are delivered.
As I write this post, invoice finance is costing around about 12% annually – or one percent a month.
These aren’t large amounts – and they only apply for the period that you USE their funding. So if you’re not in need of cash, you don’t HAVE to draw down on that finance.
Overheads of Debtor Finance
One of the overheads of debtor finance is that – particularly with older tools – the implementation can be a little complex.
Not all finance providers get what that could mean for your accounts people – my IT experience means that I DO understand – so I can make sure that we choose the right product for your business and your team.
You have to track two finance payments, as well as the actual customer payment – and you have to account for the fees and charges. This can mean that you have to run a shadow ledger and you have to manage a little bit more of a paper trail.
Typically, the benefits outweigh the costs – even with older products.
The good news today is that many of the leading debtor finance products on the market can integrate into your online accounting. That means the accounting processes are automated and the overheads are substantially less.
Ease and availability
As I said above, invoice finance is currently around 12% annually (1% per month). It can typically be put in place within 2-3 weeks – much faster than a bank loan.
By comparison, general-purpose cash flow loans range from 15-18% up to 25-26%. These are being heavily marketed for their ease and speed.
Sadly, a lot of people tend to get seduced by these loans because they’re relatively quick and easy to obtain (if you have the assets to secure them).
Very often, a long term invoice financing tool is a far better option to look at for growing your business and relieving your Cash Gap stress.
Which Invoice Finance is right for your business?
There is a growing range of Debtor Finance tools in the market – with some super-powerful features. The “right” one to use is one that meets your business needs with a minimum of administrative overheads.
There are a couple of recent financing tools that are really flexible and powerful. TP24 is one current example.
Trade Plus 24 – smarter debtor finance
There’s a product called TP 24 or Trade Plus 24 – which is a smart new way of doing debtor finance.
Trade Plus 24 simplifies a lot of administration issues because it plugs directly into your online accounting system – be it Xero or MYOB – and is able to read the debtors you have at any given time.
So for example, let’s say you’ve got $500,000 worth of debtors. (It can be as little as $200,000.) Trade Plus 24 monitors those debtors and can see in your accounting system on a daily basis what your current debtors are and how much money you’re owed.
They will lend you a percentage – and often up to 80% of that value – in the form of an overdraft type facility that you can draw on (or not) as you need it.
Trade Plus 24 will be sitting there monitoring what’s happening with your debtors – and at any time you can draw down up to 80% of that value. WITHOUT ongoing loan applications, approvals, security requirements or invasive personal questions.
It’s a very easy and flexible facility and operates like a traditional overdraft – when you don’t need it, you don’t draw down any money and you don’t pay any interest.
Increasingly, businesses today have a good digital accounting system, and with this sort of tool, it simplifies the implementation and the administration of debtor finance.
Any business financing strategy needs to be matched to your business.
Which business financing tools are best for your business? That depends on your business and it’s specific situation.
For many SMEs, trade finance tools are used in conjunction with debtor finance, but they don’t have to be.
Take a moment to look up the value of your current invoices that fall due in the next 60 days. Write down the total.
Ask yourself if 80% of that amount today would let you run your business better today?
If the answer is “yes” then book a strategy review with Cash Flow Strategist Martin Cattach today.
