By Terry Haydon*
All business owners and their accountants are aware of the importance of working capital and the critical role it plays in the business cycle but few understand how the provision of working capital has been “hijacked” by banks and financiers over the years.
Why is a particular class of assets, known broadly as accounts receivable and which is a major contributor to the need for additional working capital is not itself being maximised to provide for its own funding? It would be to the borrower’s advantage.
An example of an account receivable is an invoice that a customer is obligated to pay within a defined period, usually within 30 to 90 days. Some key characteristics are:
- it is typically unsecured;
- it typically represents an identifiable sale of goods or service;
- it is a legally binding obligation with remedies for recovery;
- when amalgamated with the balance of a month’s sales it represents a fundable asset with a spread of risk over multiple invoices and normally many debtors;
- with the advent of the PPSA those unsecured third party financial obligations can be converted to secured financial obligations, which become prime security for funding working capital;
Another question is, why do banks and non-bank funders disregard the strength of debtor invoices and convey the message that the use of accounts receivable funding is a sign of weakness? It is self-serving and results in greater than necessary charges being incurred by the borrower. Strangely only the financiers benefit!
Contrary to the above questionable message, it is the smart business operator that uses their best assets to secure working capital funding because it is typically cheaper than a bank overdraft and also generally results in a greater level of funding being made available.
Why is this?
As with all assets, accounts receivable have to be managed. The commercial banks prefer a more passive security portfolio, i.e. property, and they are not geared to manage a dynamic asset like accounts receivable. Hence the general misuse of less liquid property to secure working capital funding.
Some current funding providers, bank and non-bank alike promote a confidential factoring product on the above mentioned “weakness” premise, claiming that it is beneficial to keep hidden the fact that accounts receivable are being used to fund working capital. But it is not financially beneficial at all to the borrower! The real reasons may well be to disguise the funders inability to effectively and efficiently manage accounts receivable ledgers and to justify charging a premium of between 7 - 12% pa over and above standard interest rates.
This can be seen by:
- bank overdraft (supposedly the benchmark) rates of approximately 15 - 18% pa;
- confidential invoice financing having a cost of credit of 20 - 50% pa;
- single invoice funding having a cost of credit of 45 - 95 % pa.
We consider that when using best practice that working capital funding should cost around 10.5% pa. In addition, some additional administrative costs are inescapable.
Consumers must be told of borrowing costs but SME’s need not be
In most cases consumers are protected by the Credit Contracts and Consumer Finance Act (CCCFA) and the Financial Markets Conduct Act (FMCA). However business owners have little such protection.
As noted by the Commerce Commission it means that without clear guidelines SME owners are being misled as to the true cost of credit.
It is disappointing that there is no compulsion to show the true annual interest rate and thus providers are able to confuse borrowers by publishing flat rates and not the true interest rate.
The Commission’s view is that disclosing the flat rate without a clear explanation of how the interest is calculated has the potential to mislead customers. Without a clear explanation, customers may not understand the basis on which the cost of credit has been calculated and/or assume that the flat rate is the same as an annual rate. This may give rise to a possible breach of the Fair-Trading Act.
If the Commerce Commission is unhappy with the use of a flat rate calculation it’s likely horrified by the antics of some online lenders who do not offer an interest rate at all. Only a repayment sum that conveniently disguises their annual interest rate. Rates which can reach up to 95% pa.
It is hard to understand why you would purposely place business lending practises outside of the protection provided to consumers and depositors.
A smarter way
There is a smarter way to assist a business that wishes to maximise the borrowing potential offered by its accounts receivable and fund its working capital from a position of strength.
The answer is in the business owner’s own hands and that the interest rate for working capital for best practice operators should be about 11 % pa.
But how are SME’s going to be made aware of and take up this opportunity if they are incorrectly told by self-serving financiers that using their best, most fundable, asset shows weakness rather than good sense>
It is not really the regulatory authorities place to help and they are not going to; the financiers whose margins will be significantly reduced if they adopt a more open and truthful stance have shown complete disinterest.
So, who will act as an independent professional advisor?
The most suitable and sensible option are open minded accountants.
A chartered accountant who sees the opportunity can seek to protect their clients’ business and reduce their cost of credit by:
- providing a warrant of fitness (“WOF”) as to current borrowing facilities and make the WOF report part of any future annual review;
- offer advice on how to become a “best practice operator” and gain the substantial benefits of both lower funding costs and reduced exposure to bad debts;
- helping businesses get the best out of their asset base;
- developing a pivotal role in the funding of working capital facilities for SME’s in their local area of operation.
Terry Haydon is the managing director of Auckland-based working capital funder, Cashflow Funding Ltd. This article first appeared here and is reposted with permission.