Debtor Finance in Australia
Australian Financial Review 3 March 2005 Invoice Discounting is growing at a breakneck pace of 26% pa
Why is "Invoice Discounting" (also known as Factoring and Debtor Finance) growing at such an extraordinary rate?
Australian banks are the second most profitable in the world, second only to Switzerland! They have a mortgage mentality driven by Australia's high level of real estate ownership; that leads Banks to seek additional security for any form of funding.
In a typical scenario a client, ABC Pty Ltd, will approach a bank for a loan to acquire a business, the bank will firstly review the collateral security available, i.e. the homes of the directors of ABC Pty Ltd. Secondly they will look at the business and make a decision based on the potential for the business to generate sufficient cashflow to enable ABC Pty Ltd to service the proposed debt.
Often the bank will boost their security by placing a charge over all the assets of the business as well. So assuming the business is worth $500,000.00 the bank will have a mortgage over the Director's homes up to a maximum of 80% and a charge on the business:
| Asset | Value | Initial Mortgage |
Security | Surplus | |
|---|---|---|---|---|---|
| Director 1 | Home | $800,000 | $350,000 | $290,000 | $160,000 |
| Director 2 | Home | $900,000 | $550,000 | $170,000 | $180,000 |
| ABC P/L | Business | $500,000 | $500,000 | ||
| Total | $2,200,200 | $900,000 | $460,000 | $840,000 |
From the above you can see that the bank has secured the funding for the business against the homes of the two directors and by taking a fixed and floating charge over the business. So essentially they hold security of $1,300,000 for a loan of $500,000. Effectively the bank secures the director's properties 100% because the remaining 20% is generally considered higher risk and is therefore not a viable security option. So whilst on the surface they only hold $460,000 security, in reality they hold $800,000, being the security plus the surplus.
What happens when ABC P/L starts to grow? They will go to see the bank and provide all their financial statements etc. and the bank will review its exposure and make a decision. The problem is that increased business is hard to explain in historical financial statements! If the bank says "no", then there are very few options available to ABC P/L, because the bank owns all of the company's assets.
This is where Factoring or Debtor Finance comes in to play.
In a growing business one of the biggest assets are the accounts receivable. By using debtor finance or factoring, a company can get access to the money it is owed and this cashflow is directly related to the company's growth. The more you invoice the more funds are available.
The only challenge facing ABC P/L will be to get their bank to release the debtor's ledger from their fixed and floating charge.
Debtor Finance provides funding for growing companies. It is not a facility to assist businesses that are financially unsound, unless the business is experiencing difficulties due to cashflow constraints derived from funding increased turnover.
There is a cost associated with this method of funding and that cost must be offset in some way, typically this is addressed by one of the following:
- Increased Sales
- Supplier discounts through paying cash, 7 day accounts, or the ability to place larger orders and obtain bulk discounts
- Pass the costs on directly to the client
- Taxation advantages i.e. topping up Superannuation prior to year end
Now that ABC P/L has secured a debtor financing facility, increased sales are funded directly from the invoice value, giving ABC the flexibility to grow their business without any cashflow constraints. The small cost of the facility is being offset by the increased profits and by taking advantage of 7 day payment terms from suppliers.
From the above you see that Debtor Finance, Factoring or Invoice Discounting is about empowering business to grow without the rigid constraints imposed on cashflow associated with traditional funding options.
When selecting a Debtor Finance, Factoring or Invoice Discounting Company it is important to find one that allows sufficient flexibility for the business' requirements. An example of this would be having the ability to fund, factor or discount as little as may be required i.e. if the business is turning over $200,000 per month but only $50,000 is required, then a facility that can accommodate the lesser amount without having to pay for $200,000 is more cost effective.
Some Invoice Discount, Debtor Finance or Factoring Companies may appear to have lower costs, but in reality force a business to fund its entire turnover. The business ends up paying for funds it does not require. Some others seek security in a similar manner to many banks.
Selecting a Debtor Finance, Factoring or Invoice Discounting Company is about matching the capabilities of that company to the capacity, needs and aspirations of the client business.