debtor finance

Does debtor financing still retain its stigma?


Debtor financing houses, most notably controlled by South Africa’s biggest banks, have gone a long way over the past few years to rid the industry of the stigma attached to debtor financing. Yet, a number of credit extension professionals still view applications from potential debtors that have elected to finance their receivables as risky, according to Frank Knight, MD of Debtsource – a credit management outsourcing company.

“Trade credit lenders are often of the opinion that debtor financing is a financing arrangement of last resort, and are therefore dubious of the liquidity of the business and their customer’s ability to settle accounts timeously.”

Knight says that there can be little doubt that the financing houses of today offer a professional and viable debtor financing solution, which only serves to deepen the mystery of the paradox that exists between what the financing houses offer, and the perceptions of other creditors – notably trade creditors. The answer of course lies in the underlying reason as to why the customer chose this form of financing solution.

For some companies financing their debtors makes a whole lot of sense. They are able to leverage working capital without creating an additional liability and perceive that the financing house will provide a professional credit control administration service. Typically they are entities with higher margins – ideally as much as 30% gross margin – and are able to apply the additional funding effectively within their business, usually for expansion or growth.

When, however, a company chooses debtor financing purely to bolster existing cash flow, trouble could be on the horizon says Knight. “The first problem is that debtor financing is expensive. This is true not necessarily in respect of the financing house’s administration fees or even the loan percentage offered, but rather the size of the loan granted against the receivables book. By example if a company uses their debtors to secure an overdraft, they are usually extended some 25% of the value of the book as a facility. In a debtor financing environment loans of up to 80% of the debtors book are not uncommon, which means that the overall Rand value of financing increases dramatically, even if the same loan percentage is applied. For a business that does not have high margin or suffers from a weak cash flow the additional costs could be crippling.”

“The second problem is that companies elect to finance their debtors, as opposed to investing in effective credit management strategies first within their own business. If a company’s liquidity is largely dependent on the quality of the debtor’s book (coupled with the payment culture that the credit department is able to create within the customer base) it becomes quite clear that no financing house will be able to effectively solve the medium to longer-term liquidity of the entity. Simply put – will the company still need to enter into a financing arrangement if debtors are paying according to their terms and there are minimal bad debt losses?” Knight feels that this point cannot be stressed enough, as all too often companies treat the cash flow symptoms without addressing the underlying cause – in this case overextending their debtor position.

“The third problem is that within certain debtor financing arrangements the financing house controls the credit process. As they are involved in the financial aspect of commerce they may – in instances – be restrictive in terms of authorising sales and may not be focused on the client’s “need for the sale” or the “bigger trading picture”. Knight says: “A credit decision in especially trade credit is based on more than just the applicant’s credit worthiness. These typically include:

  • The potential profit of the proposed sale in comparison with the anticipated risk (a high margin may justify a high risk transaction)
  • How much is the sale needed – in a manufacturing environment it may be necessary to accept additional orders from marginal clients to ensure that the factory is kept running and staff are employed
  • Stock disposal – in some situations a company may be overstocked, including damaged or redundant stock for which they secure a marginal credit buyer. It may potentially be more profitable to allow the purchase than to retain the stock.”

Given the potential pitfalls of debtor financing as discussed the astute credit professional is well advised to question the underlying motive for their customer’s decision to use debtor financing as a financing alternative, however it would be naïve to assume that any company that finances their book via this vehicle should be deemed a higher credit risk says Knight.