Finance Market Update - 21 March 22
One of the biggest killers of small business is the cash flow gap. In this fortnights update we talk about business cash flow and a financial solution that could help solve the problem.
Mind the gap
Winter is coming and that can mean slower months for many businesses. Slower months can mean less cash flow. Less cash flow can kill businesses.
Many businesses have what is commonly referred to as ‘cash flow seasonality’ which refers to when a business has high and low months of sales and cash flow over the course of a year, every year.
But almost every busy needs to manage cash flow between paying suppliers, bills, and getting money from their customers. The difference in the time it takes between paying for stock or goods or delivering a service and then getting paid for it is called the cash flow gap.
As you can see in the very illustrative and artistic graph below cash flow gaps can occur when a business needs to pay suppliers but does not get paid by their customers until later.
The cash flow gap is what kills a lot of businesses.
The cash flow gap is the difference between your money out and money in on goods (stock, inventory, labour) and services you have provided.
In this example the business is paying their supplier 30 days after stock is received. This is pretty common time frame but in fact many suppliers require a deposit before they even ship the goods, which further extends the cash flow gap.
It takes time for the business to sell the goods. In this example we assume 15 days after they were received.
But the invoice timeline for payment for this businesses customers is 60 days. That is a lot of time between when the business has put money out the door to pay for stock before they get paid by the customer.
It is better to have shorter payment terms with your customers, but sometimes large customers have enough weight to ask for longer terms or it is industry standard that you need to abide by.
In this case the business is out of pocket and could have serious cash flow issues. They still need to pay rent, wages and all the other costs of running a business but there is a mismatch on money in and out.
So, how does the business fill this gap?
Cash or finance.
If they are in a positive cash flow or capital position they could just use cold hard cash, but this is not the case for most businesses. And even then unexpected costs come up which could blow the budget.
This is where many businesses use finance.
They borrow money to help bridge the gap and support their cash flow. It is imperative that the business has enough cash flow to meet expenses, but ideally to continue to grow. Having the right kind of finance in place to support the business operations and growth plans can make all the difference.
This is often the big challenge for businesses of any size, managing cash flow.
Fortunately, there are a number of solutions that can help here, let’s talk about one in particular.
Let’s talk about Debtor Finance
There are many forms of finance available for a business and one of the increasingly common and important products is called debtor finance.
There are other products, check out the link below to a video interview we did with Zip Business on their fintech products.
Debtor finance is a finance product that uses a businesses invoices as security to essentially get a cash advance on those invoices.
Following on from the example above, you can see where debtor finance covers the gap.
We see in this example that there is no longer a 60-day cash flow gap. Debtor finance funds the 45 days difference at a % cost + fees which gives the business cash to order new stock and start the cycle again.
This means the cash flow gap is filled in by finance and supports the business to keep running and growing.
This is particularly useful for businesses with seasonal cash flow and with B2B customers and suppliers. It is also very appealing for a business owner who does not have and does not want to put up a property as security for a business loan.
It can be an amazingly effective form of business finance that improves cash flow and is very flexible to suit your business.
We use this product with clients to help with working capital and cash flow.
In terms of interest rates for debtor finance it is effectively a sliding scale that considers the age, size, revenue, mix of debtor ledger, industry, debtor days and credit profile of a business.
Generally speaking, it is cheaper with a lower interest rate than a unsecured business loan but more expensive than a property secured loan.
There are two main types of debtor finance, sometimes called invoice finance, which are ‘invoice discounting’ and ‘invoice factoring’.
Invoice discounting keeps the responsibility of collecting payment of invoices from the customer with the borrowing business. This can be most suitable for businesses with an established client book with good repayment history. This product can be ‘disclosed’ or ‘undisclosed’ which refers to whether the funder doing the finance needs to be ‘disclosed’ to your customers and noted on invoices to be paid.
Invoice factoring puts the responsibility of collecting the payment of invoices with the funder who is providing the facility. This is good for a business who does not want to deal with collecting payment of invoices and spend time focused on the business. Because the funder is doing more work in collecting the invoices it costs more than the discounting version.
Depending on your business, your customers and cash flow needs will determine which of the two versions is right for you. This is something Skyward Financial can help work out.
Here are a couple of useful financial ratios to think about if debtor finance is right for your business is.
Debtor Days = Trade Debtors / Revenue x365. This tells you the average number of days you are getting paid on invoices from your customers. For debtor finance this number should be over 30 and less than 120. It will also indicate if you should collect payments faster.
Stock Turnover = Revenue / Average stock held. This tells you how many times stock needs to ‘turn over’ to get to your sales figure. As in, you need to sell X amount of your products on average to meet your sales numbers. If your number is 20, then you need to sell 20 times your average stock held to meet your sales.
Both of these ratios help you to know if debtor finance might help with you cash flow. If you are getting paid late by customers or have a high debtor days ratio it can help cover the gap. If you are sitting on a lot of stock for sales that can eat up cash and debtor finance can help.
But like all finance there are considerations, for debtor finance it is important to understand what you are signing up to.
For example, when you use a debtor finance product you get around 80% of the invoice(s) you fund. You the get the remaining 20% less cost and fees when the invoice is paid by the customer. So, in this example if you funded a $5,000 invoice you would get $4,000 upfront and the remaining $1,000 less cost later on, usually in 30, 60 or 90 days depending on your billing cycle.
Most funders will require repayment of a late invoice at 120 days overdue. This means you need to ensure the invoices are paid when they are due and to not turn into bad debt as the interest costs a lot over that 120 days and you still need to repay the full invoice amount to the funder.
Debtor finance can be an extraordinary product for a business to get cash flow support to running and growing. If you are interested in working capital solutions like debtor finance Let’s Talk.