Accounts receivable financing
/What is Accounts Receivable Financing?
Accounts receivable financing involves the sale of one’s accounts receivable in exchange for a working capital loan. Receivables are considered a highly liquid asset, and so are one of the best forms of collateral for loans. The amount loaned is somewhat less than the amount of the receivables being used as collateral, which can be up to 90% of the face value of the receivables. Customers are instructed to send their payments to the lender, which retains all funds received. The lender makes money on the difference between the amount of cash received from collecting receivables and the amount loaned to the business. The risk of receivable default is transferred to the lender, since it is buying the receivables. Because of this risk, the lender may only accept receivables from larger and more creditworthy customers of the borrower.
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The Nature of Accounts Receivable
The accounts receivable balance reported by a business is comprised of the unpaid invoices that it has issued to its customers. These invoices are also known as trade receivables. These invoices are usually payable within a short period of time, such as 30 days from the invoice date, and so are one of the most liquid assets owned by a business. As such, they are considered one of the most prized assets that lenders can access, since receivables can be readily converted into cash. If a business owns a large amount of current accounts receivable, then it is in a good position to engage in accounts receivable financing.
When to Use Accounts Receivable Financing
Because of the high level of paperwork involved in the arrangement and the risk of customer defaults, the interest rate associated with this type of financing is quite high. Consequently, it is typically only used by businesses that cannot enter into more reasonably-priced lending arrangements. The type of business that will find accounts receivable financing to be most attractive are those with little available cash and rapid growth; they need to finance an expanding amount of receivables, but do not have the cash to pay for the underlying inventory.
Another situation in which receivable financing can make sense is when invoice terms are quite long. This situation can arise when a start-up company is forced by a customer (frequently a large retail chain) to accept lengthy payment terms, perhaps in the range of 60 to 120 days. In this case, the business typically has minimal available financing, and yet must support lengthy receivable terms. A lender can assist in this situation by making an immediate payment to the company under an accounts receivable financing arrangement.
The Cost of Accounts Receivable Financing
Accounts receivable financing is one of the more expensive types of financing. Its exact cost depends on several factors. First, lenders charge an upfront fee to reimburse their underwriting and origination costs. This fee can increase in size if the prospective arrangement is a large one or is unusually complex. Also, if the arrangement is for occasional financing, rather than an ongoing arrangement, then lenders may insist on charging the upfront fee again whenever more funds are requested. In addition, the company must pay a processing fee every time a customer pays for an invoice. The amount charged is usually a percentage of the face amount of the invoice. If the quality of the invoices used is high and they are easy to collect, then this lowers the cost of financing. Individual lenders have different rate structures, usually because they are trying to attract different types of customers. Consequently, it make sense to shop around to find the rate structure that best applies to your particular situation.
Example of Accounts Receivable Financing
For example, a shoe store chain orders $50,000 of shoes from a shoe manufacturer. The chain demands 90-day payment terms from the manufacturer (“net 90” terms). Once billed, the $50,000 is part of the manufacturer’s accounts receivable for the next 90 days, until payment is received from the shoe store chain. The manufacturer elects to transfer the invoice to a financing company in exchange for a 90% cash advance, resulting in a cash payment of $45,000 right away. Ninety days later, the financing company collects $50,000 from the shoe store chain, netting itself a $5,000 profit.
Underwriting Considerations
The amount of cash that a borrower receives from an accounts receivable financing deal will depend on the quality of its customers and the age of the associated receivables. When invoices have been issued to large, financially stable customers, then a lender is more willing to pay a large proportion of the face amount for these invoices. Similarly, if the borrower’s invoices have not yet reached their payment dates, they are more valuable to the lender. Conversely, old invoices issued to smaller and less stable customers will only attract a low proportion of financing to invoice value; a more cautious lender might not accept these invoices at all, resulting in no prospects for financing.
Advantages of Accounts Receivable Financing
There are two key advantages to accounts receivable financing. First, it allows a business to obtain very fast access to funding without having to wait for the paperwork approvals commonly associated with most business loans. The time required to obtain receivable financing may be just a few weeks, versus several months to obtain a loan from a bank.
Second, when receivables have been sold to a third party, the borrower no longer has to worry about receivable collections, since this task is taken on by the party that acquired the receivables. This may allow it to reduce the size of its collections staff to handle only those receivables that it has not sold off. However, the lender will have only taken invoices from the safest customers, so the borrower will still have to collect from its more marginal customers.
Disadvantages of Accounts Receivable Financing
A downside of receivable financing is that customers may learn about the arrangement, since they are being asked to send their payments to a different address. This issue can be mitigated by characterizing the payments as going to a lockbox for cash management purposes. Nonetheless, news about the arrangement can give customers the impression that the business is having financial difficulties.
Another concern is that the interest rate charged in these arrangements is quite high, which can severely impact a borrower’s cash flows and reported profits. When the margins of a business are already relatively low, it is quite possible that adding on the cost of accounts receivable financing will result in losses, requiring the borrower to eventually go out of business.
A further concern is that, if too many customers default on their payments, a lender may suddenly cut off any additional financing. If so, the borrower may find that it does not have enough time to find alternative financing, requiring it to default on its debts.
How to Apply for Accounts Receivable Financing
There are several steps to follow when applying for accounts receivable financing. First, create a forecast for the next few months and determine the size of your projected cash shortfall. Next, review your list of outstanding invoices, and strip out any for which the probability of payment by customers is relatively low. The remaining invoices will be reviewed by lenders. In addition, assemble the company’s most recent bank statements and tax returns, as well as its business license, tax identification number, and articles of incorporation. Lenders will want to review this information as part of their credit analysis. They will also run a credit report on the company. It may be possible to make these document submissions online, after which lenders typically require a few weeks to review the information and decide whether to enter into a lending arrangement. Once approved, funding can be arranged within a few days.
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