Is business expansion being hindered by a lack of funds? It’s time to get acquainted with debtor finance – ‘dynamic’ finance that grows in line with turnover.
By Glenn Baker.
In a fast-paced business world that’s constantly being disrupted by new technologies and new ways of doing things, it’s easy to forget some of the tried and trusted tools out there which business owners can rely on to solve specific problems.
Debtor finance is one such tool – a funding mechanism that’s based on a business’s balance sheet assets; specifically money owed from the sale of goods or services that can be leveraged off straight away.
If you’re not familiar with debtor financing, or the even more obscure term ‘factoring’, then the Debtor and Invoice Finance Association of Australia and New Zealand, provides a reasonably clear distinction:
“Factoring and discounting, also known as cashflow or debtor finance, are among the most powerful financial tools available to business. Invoice discounting simply involves a business turning its unpaid invoices into cash. The business literally sells its unpaid invoices to the discounter.
Factoring involves the sale of a business’s unpaid invoices as with discounting, but in addition the sales accounting functions may be provided by the factor, who manages the sales ledger and collection of accounts.”
For further clarity, NZBusiness spoke first to Wayne Goss, general manager New Zealand for Scottish Pacific Business Finance, which has been providing debtor finance solutions to New Zealand and Australian businesses for more than 25 years. Goss has seen a lot of developments in this space in his time at Scottish Pacific.
“The largest change has been through the development of cloud-based technology, where Scottish Pacific led the innovation. The use of cloud technology allows customers greater accessibility, insight and control over their facility in real time,” he says.
Lock Finance is another major player in the debtor finance space, and has been providing specific debtor financing products for some 18 years. Craig Brown, general manager lending for Lock Finance, believes the improvement in technology has allowed a much higher level of visibility for clients that use the facilities. “Also, the pricing has become significantly more competitive with the general banking products.”
So who should use factoring or debtor financing? Is it for all businesses?
“Debtor finance is best suited for businesses that sell goods or services to other businesses on standard trade credit terms,” explains Goss.
“There are a multitude of reasons why businesses select debtor finance. However, at Scottish Pacific we’ve found the most common to be businesses experiencing strong growth.
“These businesses find that other forms of finance cannot keep up with their growth and hinder expansion. Debtor finance facilities are dynamic and grow in line with turnover, providing additional funding as the business needs it,” he says.
Other common reasons to choose this form of finance include:
- There’s no requirement for real estate security, “allowing those without ‘bricks and mortar’ assets to borrow for the business against their business, keeping personal assets secure for the future”; and
- Director preference to outsource the debtor administration, to free up time to focus on strategic decisions and growing the business.
At Lock Finance, Craig Brown agrees that the flexibility of debtor finance suits fast growing businesses. “Importers, wholesalers, manufacturers and B2B service providers suit this type of financing. This is because those businesses generate commercial invoices that we can leverage against at a much higher level than the banks are prepared to.”
He says over the years one of the biggest challenges has been the acceptance of the products in the business finance market. Business owners have been conditioned by the banks to utilise an Overdraft and Term Loan as their primary financing options, he says, when other lending facilities would have been more suited.
“This eased somewhat when one of New Zealand’s largest banks entered the market by offering an invoice lending product.
“One of the biggest reactions a client may have is that ‘we don’t want our customers to know that we have a finance company financing our invoices’,” says Brown. “This is why we specialise in invoice facilities where the customers don’t know we’re involved.”
Goss at Scottish Pacific believes the overall perception of factoring and debtor financing is changing.
“Debtor finance is becoming a more mainstream funding option,” he says.
So what are some of the most common questions he hears from business owners?
“The most common questions regarding new facilities revolve around cost. Debtor finance is typically seen as expensive in comparison to a bank overdraft; however, savvy business owners will weigh up the advantages of a dynamic facility with an optional debtor administration service. The other facilities can be undisclosed to debtors and are costed out at a comparable interest rate to overdraft facilities, with the advantage of a dynamic facility that grows with the business.”
To appreciate debtor finance in action, Wayne Goss uses the example of a wholesaler experiencing significant growth; who required a capital injection to ensure the business had sufficient working capital.
“Large orders were being turned down due to cashflow difficulties, with suppliers requiring cash up front to cover large orders,” he says. “A debtor finance facility was established, providing the needed capital boost to sustain growth and allow the wholesaler to take on new business, without the use of real estate security.”
The advantage of the debtor finance facility in this case, says Goss, was that the wholesaler was able to increase their funding limit without needing to add real estate security. “This greater funding allowed the business to continue growing rapidly without needing to turn down orders due to cashflow restraints.”
A useful client study from Lock Finance involves an importer experiencing strong growth thanks to the market they were operating in. The importer had reached its suppliers’ credit limits and required additional cash to fund more sales.
“They had already exhausted the increased equity in their house but still needed more,” says Brown. “Their bankers were also at the limit of their security against their house and wouldn’t place sufficient enough value on the business assets.
“So we provided two facilities: 1) an import facility based on the firm orders the client was receiving. This was paid by us directly to the supplier, and 2) an invoice facility that provided cashflow to cover their increased operational costs. A very good all round solution.”
A word from the wise
So what general advice can our experts offer around the whole process of sourcing and implementing a factoring/debtor financing service?
“When businesses are looking to implement a debtor finance facility, they should first consider the needs of the business; do they have a strong debt collection process already in place?” says Scottish Pacific’s Goss.
“If not they could improve the debt turn and potentially lower interest costs through the use of a full service facility with an incorporated debtor administration service.
“Is having customers unaware of our involvement important? [If so] an undisclosed invoice discounting facility could suit your business.”
Businesses must look at the factoring house they’ll be dealing with, adds Goss. “Who funds them? Are these funding lines secure or will your debtor finance facility be restricted by the availability of funds the factoring house has access to?
“Look at the factoring house’s reputation and emphasis on customer service. How long have they been operating? Are they able to provide testimonials or access to existing customers?”
Lock Finance’s Craig Brown advises business owners to make sure they understand the offering and that it fits with their business model and financial goals.
“If comparing offerings in the market then compare apples with apples. Also, make sure you arrange facilities that can fit with your business cashflow requirements – not you having to fit into something that’s not right.”
How smart tax management can assist cashflow
Q: Paying provisional tax on the IRD’s set timetable impacts cashflow and causes business owners to struggle. How can this be addressed?
A: IRD has fixed dates to pay provisional income tax. For businesses with even cashflow, these due dates are after income is earned. Business owners can be proactive by putting money aside throughout their tax year so there are no nasty surprises when provisional tax payments are due.
Where businesses earn their revenue later in the year, have seasonal income or need their cash reserves for investment purposes, the IRD fixed timetable can be difficult to meet. In these cases, businesses have a few options.
- Approaching IRD either directly or through your accountant is one option. IRD can enter into arrangements with taxpayers to help stop them getting into serious trouble. This is especially the case if tax is already overdue.
- Short-term liquidity problems can also be solved with a loan from the bank. Banks tend to be reluctant to lend to pay tax bills, so a clear need for the money for investment or specific purposes tends to be required.
- Using a tax pool intermediary is an increasingly popular option, either directly or through an accountant. Tax pooling intermediaries are registered with Inland Revenue and can arrange payment plans. There is no cost to setting up these plans or paying through an intermediary, and they can offer approximately a 30 percent reduction on interest costs compared to Inland Revenue’s use-of-money interest rates. They can also be used to finance upcoming provisional tax payments or pay income tax in monthly instalments.
Q: Interest and late payment penalties can wreak havoc on a business’ bottom line. How do business owners get themselves into strife over this, and what can they do to fix it?
A: Businesses are charged 8.27 percent by IRD when they do not pay enough tax.
When no tax has been paid, late payment penalties may also be incurred, which adds up the longer it is left unpaid:
- One percent penalty the day after payment was due.
- A further four percent if the amount of tax including penalties remains unpaid seven days after the original due date.
- An additional one percent incremental penalty every month the amount owing remains unpaid.
As you can see, late payment penalties can be a real killer. The government has recently acknowledged that they are not effective in managing taxpayer behaviour and has proposed to reduce these for any new debt with IRD relating to GST, provisional tax, income tax and Working for Families tax credits from 1 April 2017.
In the event not enough provisional tax has been paid, a business can settle what it owes the tax department through an IRD-registered tax pooling intermediary. They will pay a lower interest cost than is charged by IRD on underpaid tax, and eliminate any late payment penalties.
Q: What other advice can you offer business owners who are perhaps struggling with their tax obligations? Are there any new tax rules they should be aware of coming up?
A: Many businesses calculate provisional tax payments using the standard uplift method (i.e. paying 105 percent of last year’s tax bill).
However, the estimation method can be a good option if you think your income will be lower than the previous year. Inland Revenue only charges interest and underpayment penalties if you have paid less than your actual tax liability.
The ratio method is worth considering if your income fluctuates. This allows businesses to pay based on a percentage of their GST payments.
The government recently announced as part of its business tax reform package some proposed changes that will reduce IRD interest costs for hundreds of thousands of businesses.
Businesses and individuals who pay the standard uplift amount at their provisional tax dates and have residual income tax below $60,000, will not be subjected to interest if their final tax liability is higher. From 1 April 2017, around 67,000 taxpayers (63,000 non-individuals) will benefit from this.
Taxpayers using the standard uplift method will not be subjected to interest if they underpay at their first and second provisional tax dates, provided they pay the income tax they owe at their last provisional tax date. This is expected to see 22,000 taxpayers better off.
From 1 April 2018, businesses with turnover of less than $5 million and which use IRD-approved accounting software to perform tax calculations, will be able to pay tax every two months, based on the profit they earned in that two-month period. It is expected 110,000 businesses will be eligible.
Every business is different, so it is important to figure out what method works best.
Answers supplied by Chris Cunniffe, CEO of Tax Management NZ.