Debtor finance is a service by which companies awaiting payment from customers can get money upfront from a third party in return for a small fee. In most cases, the business will have to give back some of the money if the customer does not eventually pay. There are different forms of debtor finance, and which one a company chooses can depend on whether the company wants the customer to know the service is being used.
The aim of all forms of debtor finance is to solve the problem of cashflow. This is where a company that is selling products at a profit faces trouble because it has to pay for supplies quickly, but faces delays before receiving payments. This is a particular issue for small businesses that have less market power, and thus often can only negotiate unfavorable terms with both suppliers and customers.
There are two main types of debtor finance. The first type, invoice discounting, is effectively a form of short-term loan that carries an interest charge. The company borrows money up front on the understanding that it will use the money it eventually gets from the customer to repay the loan. The customer will be unaware of this process. In most cases, the financing company will have the legal right to seize payments from the borrowing company's customers if it fails to repay the loan.
The second form of debtor finance is debt factoring. This effectively involves selling of the debt. The finance company immediately pays the outstanding money to the business, minus a fee. It then collects the money from the customer. This has the advantage that the customer may be more responsive to a finance company's demands for prompt payment, but has the disadvantage that customers are aware the business needs debt factoring, which may give the impression of cashflow problems.
Most types of debtor finance involve a recourse clause. This means that if the customer has not paid by a set date, often 90 days from the invoice being issued, the business must repay the relevant amount to the finance company. The business then takes back control of collecting payment from the customer. In some cases, a finance company will not use the recourse system and will thus take on some of the credit risk. This usually means higher costs for the business, and may mean the finance company demands to run credit checks on the customers.
