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How to turn a potential bad debt write-off into positive cashflow

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What if an electrical contractor was given the opportunity of turning a potential bad debt write-off into positive cashflow? Andrew Birkwood, founder and CEO at Azzurro Associates, explains how.

Business can be tough. Even when things are going well and the economy is booming, trouble is never very far away. The unexpected loss of a major customer or a protracted payment dispute can put pressure on cashflow which, if not carefully managed, can soon turn a drama into a crisis. Many electrical businesses and contractors fail, not because they don’t deliver a great product or service, or even have a full order book, but more often because they don’t spend enough time focusing on the cash. 

That said, even the best run businesses will have been challenged by the uncertainties around Brexit, and even moreso by a global pandemic. And even those with professional credit management teams suffer from late payments. Contractors find themselves chasing customers for work they’ve completed, a service they’ve delivered, or a maintenance contract they’ve fulfilled. Distributors chase contractors for products long-since delivered but not yet paid for; and the manufacturers themselves struggle with payments from both contractors and distributors alike. 

What is common across all is that they typically have a large volume of comparatively small value invoices to collect. They have to balance at what stage they give up on their own collections activities and recognise that the cost has become disproportionate to the amount overdue, especially if they end up in court when there is still no guarantee they’ll get any money at the end.

So what if the finance team was given the opportunity of turning a potential bad debt write off into positive cashflow? Put another way, what if a business could effectively ‘sell’ its invoices for cash? And what if in doing so, the industry helped to effectively create a new ‘category’ of debt management solutions available to the hard-pressed finance director?

A new debt management solution

While the concept of selling debts is not new, it is new to the world of commercial credit. Whereas the acquisition of large consumer debt portfolios is ‘business as usual’, the acquisition of portfolios of delinquent commercial debt is not. It is far less typical for a business to actively seek to buy a commercial portfolio in isolation. Until now.

So how does it work? A debt ‘buyer’ values a tranche of debt at anything between (typically) 5% to 30% of its face value. Based on its valuation, this is the amount that the ‘seller’ (the electrical business) receives. The value is determined by a number of different factors, the two most important being the age of the debt and the credit profile of the debtor. A recent invoice to a large, well-established business is likely to pay a higher percentage than a very old one to a small business.

The only restrictions relating to the invoices purchased is that they have to be ‘younger’ than six years from the due date, and of a value greater than £100. There are no restrictions, however, to the volume or make up of the portfolio; they may comprise a small number of large invoices or a large number of small invoices, so long as they have a total value of £50,000 and above (to a maximum of £10 million).

Once the invoices have been acquired, the responsibility of collecting the outstanding balances rests with the purchaser. They will use a range of skills and credit reference agency data to determine the appropriate servicing strategy (i.e the collections techniques most likely to result in a successful outcome for all parties). It is those skills and insight that will identify any vulnerable customers, allowing forbearance and breathing space where required. Of the money that is collected, the purchaser shares a proportion of the collections it achieves, which can be as much as 50%, with the amount remitted to the client on a monthly basis.

Redefining cashflow finance

Other ‘cashflow funding’ options are also available. The Government has gone out of its way to support businesses with various loans, grants and other hand-outs (as of 12 July some £31.70 billion of Bounce Back Loans had been approved for 1,047,611 businesses. By the same date, a further £11.85 billion in CBILS had been granted to 54,538 different firms), but while the effects of the various rescue schemes take time to get off the ground, many cannot afford – quite literally – to wait.

Businesses might therefore look to more ‘traditional’ methods of cashflow funding including various forms of invoice finance (factoring, invoice discounting, asset-based finance etc) where the amount of money available is directly linked to the invoices generated. Again, however, such financing has its drawbacks and relies on a constant flow of business and invoicing. As business dries up, so does the cash.

Invoice finance providers advance cash against invoices that are still within term (i.e. 30 days), whereas debt buyers provide cash for debts that are overdue or delinquent, and that a business is struggling or has failed to collect.

This is an important distinction: whereas the amounts advanced (typically 80% of the invoice/sales ledger value) appear much higher than the amount offered for debts that are sold, they are not comparing like for like. Very few CFOs realise that there is any value in delinquent debt; fewer still, perhaps, are aware that such unpaid invoices can be instantly converted into cash – cash that can be used to invest; cash that would otherwise have simply been written off.

It is probably fair to say that there has never been a more important time for businesses to be able to extract value from their unpaid debts. As coronavirus leads to more businesses failing to pay their suppliers, businesses further up the supply chain need to make sure they don’t run into liquidity problems. 

If there is an up-side to the Covid-19 crisis it is that it has once again obliged businesses to look at their most important asset, and understand the critical importance of cashflow. The speed with which some businesses ran out of cash has been alarming, but the speed with which others re-focused their credit teams was rather more uplifting. Interim small business commissioner Philip King, whose office champions fair payment practices and supports businesses looking to resolve payment disputes, said that “….at times like these we need creative ideas.”

Commercial debt purchase – and the emergence of a new genre of debt management solution – is one such ‘creative idea’ that is likely to have traction long into the future.

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