Use your customers to fund your business growth: debtor financing explained

I suspect there are a number of reasons for this. One reason might be the perceived stigma. Often, debtor finance companies will require that the arrangement be disclosed to the customers of the business and collection of the outstanding debts is handled by the debtor finance company. Whilst this needs to be carefully managed, I do see a “good news story” in here for the business and that story should be “sold”. The business is growing! Every business owner understands that a growing business needs to fund cash. So should your customers.

Secondly, the business is “outsourcing” its debtor management, thereby enabling the owners to focus on doing what they do best – build the business. You may also find that your debtors are better managed (and more likely to pay on time) when there is greater focus applied.

Another reason may be because debtor finance is generally a more expensive form of funding than traditional bank finance secured by a property. This is not surprising – it’s more risky. If the business owner had property to put up as security then they wouldn’t need debtor finance. So it is important to understand what the cost of funds will be. Even if the effective cost of funds is (say) 15%, provided the business is making a return on capital employed (ROCE) of greater than this then they are in front. In other words, if the ROCE for the business is, say, 25% then the business owner is still in front by 10% once the financing cost has been paid. Would you rather make 10% of something or 100% of nothing?

I have certainly seen debtor financing used to beneficial effect by one second-generation family business client, where the children (who recently took over the business) had little or no “bricks and mortar” security.

Clearly, in a perfect world having access to an unlimited supply of cash is utopia. However, we don’t live in a perfect world and business owners frequently have to deal with imperfection. The challenge for business owners using any sort of funding, but particularly debtor financing is to know the key financial parameters of their business.

The big three financial ratios every business needs to know

1. Know your ROCE. If you don’t know this and the areas of your business that drive it, you’re driving blind.
2. Know your free cash flow (FCF). Work out your after-tax profit. Subtract from this the amount by which the capital employed in the business has grown during the year (or last year). If the answer is negative, you have negative FCF and this can’t be sustained forever.
3. Know your Working Capital Absorption Ratio. This is simply the amount of additional working capital your business will need to fund a given increase in sales. This can vary significantly from business to business. If you don’t know this and you have a growing business, you’re in risky territory, unless of course you have an endless supply of cash.   

Grant Field is the chairman of MGI and has over 30 years providing accounting advice to businesses.

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