Using Your A/R to Fund Your Short-Term Capital Needs
With many banks maintaining a tight hold on their cash assets, companies are finding it difficult to get the funds they need to keep their businesses going and growing. Small firms, of course, struggle most, but organizations of all sizes are feeling the pinch. Receivables Based financing may provide a solution.
What is Receivables Based Financing?
Accounts receivable are one of the most liquid assets any firm holds. As such, they make excellent security for short-term loans needed to cover payroll, materials, costs tied to production, and even expansion.
Receivables (A/R) based financing involves the use of the borrower’s accounts receivable (credit) sales to secure short-term loans. It’s a form of asset-based lending, but instead of using a combination of inventory, equipment, receivables, and other assets to secure the loan, only the organization’s accounts receivable are pledged.
Receivables based financing is available through banks and independent investors specializing in this type of lending.
Receivables-based Financing is NOT Factoring
The terms Receivables Based Financing and Factoring are often used interchangeably. This is unfortunate because they are not the same. Both are a means of using receivables to obtain immediate cash flow. And both are usually considered transitional sources of financing. A/R based financing, however, uses receivables to obtain a loan, while factoring is the sale of the receivables to a third party.
A/R Financing vs. Factoring
- A/R financing is generally less expensive than factoring.
- With A/R financing, the borrower maintains control of its relationship with its customers and is responsible for collecting the invoices. When receivables are factored, the factor becomes the owner of the receivables and is responsible for invoice collection.
- The “fee” paid with A/R financing is a percentage on the amount of the credit line that is actually used by the borrower. The factoring fee is based on the face value of the total invoice.
- With A/R financing, it’s easier to transition to a traditional bank line of credit as the corporation becomes “bankable”.
Who uses A/R Based Financing?
Any manufacturing, distribution, or service company requiring short-term financing to manage its business may find A/R based financing of value.
This type of loan is particularly useful when:
- The organization urgently requires cash to stay in business.
- The bank refuses to grant unsecured credit.
- A higher line of credit is required than the bank will provide.
- A short-term increase in cash is required to fund an expansion opportunity.
- A major customer slows down its payments causing the creditor to face a serious cash flow issue.
New organizations that have not yet developed a credit track record of their own, however, will generally be unable to obtain A/R based financing. If short-term cash is required, factoring would be a possible option.
How does A/R Based Financing work?
Lenders, including banks and private entities specializing in this type of lending, analyze the firm’s receivables to determine how much to lend against them. Of consideration is the age of the receivables, the credit rating of the firms’ customers, and the borrower’s own credit worthiness.
The borrower provides the lender a schedule of its A/R including the names of the accounts, billing dates, and amounts owed. Some lenders may require copies of invoices or other documentation proving that the sales are legitimate.
The loan may be denied for a number of reasons including:
- The borrower’s business is too new and hasn’t yet developed a track record with the lender.
- The borrower has not yet established a credit rating or the rating is low.
- Concentration of more than 20% of sales with one customer.
- Dilution, that is, the portfolio of receivables contains a high percentage of returns and chargebacks.
- Monthly sales do not meet the level required by the bank.
The lender does not have to accept all of the borrower’s receivables. The accounts receivable will be scrutinized, and receivables may be rejected for reasons including:
- Aging: Each lender has its own rules. Receivables more than 30-60 days old may be rejected, or the lender may provide financing on all receivables up to 180 days old.
- Creditworthiness: If the buyer has a low credit rating or is not rated.
- Government and foreign accounts are usually ineligible.
Typically, lenders advance between 50-90% against the face value of receivables deemed appropriate to secure the loan.
A receivables secured loan can be made on a non-notification or notification basis, which determines to whom the borrower’s customer will make payments.
- Non-notification: In the case of non-notification, the borrower’s customers are not notified that their accounts have been pledged to secure a loan. The customer directly pays the seller/borrower, who then forwards the payment to the lender. The lender checks the payment against the schedule of receivables securing the loan and reduces the amount the borrower owes by the percentage advanced on the A/R. The balance, less any interest accrued, is credited to the borrower’s account. Under this arrangement, the lender takes the risk that the borrower may withhold some payments.
- Notification: The customer is notified of the assignment and makes the remittance directly to the lender, who reduces the amount the borrower owes by the percentage loaned against the receivable (for instance 75%) and then the balance (in this case 25%) is credited against the borrower’s account.
Advantages of Receivables Based Financing
- A loan secured by receivables is usually a continuous financing arrangement. As the firm generates new receivables that are acceptable to the lender, they are pledged and added to the base from which the firm can borrow. Old receivables are replaced by new ones, causing the amount of the loan to fluctuate. The more sales the firm makes, the more money (cash flow) is available to finance its short-term requirements.
- These loans do not require a monthly principal payment.
- They enable the organization to grow at an almost unlimited rate. The more credit sales you generate, the more money you are advanced.
Disadvantages of Receivables Based Financing
- This form of financing generally costs considerably more than an unsecured bank line of credit. However, if the firm has maxed out its bank credit line or is not in a position to get such financing, securing a line of credit with their accounts receivable can help them fund day-to-day expenses.
- Firms using this type of financing are often required to be more rigorous in managing and reporting on their accounts receivable. This is not necessarily a bad thing and the borrower could end up with a much more efficient and effective A/R department as a result of this requirement.
- The borrower may lose flexibility in negotiating terms with its customers because of the bank’s requirements for providing the financing
Businesses with unstable cash flow, such as seasonal sales or rapid growth, may find accounts receivable financing as a viable strategy for getting the capital they need to stay ahead of day-to-day business operations and take advantage of growth opportunities. Rather than waiting for 30, 60, or 90 days or more for customers to pay, leveraging unpaid invoices could be a great option for fast access to capital.
Before deciding to pursue accounts receivable financing or another kind of business loan, make sure to consult with your accountant and consider all options in finding the right lender for your business.
Check out these other credit management articles below:
- Basic Outline for Developing a Credit Policy
- Cash Flow and DSO
- Credit and Collection Policy Basics
- Credit Extensions are Loans
- Credit Group Spotlight: GAIN
- Credit Group Spotlight: NCCA
- D/P, D/A and Their Use in International Sales Transactions
- DuPont Analysis
- Final and Binding Arbitration: A Quicker, Cost Effective Alternative to a Lawsuit
- Measure and Manage Collection Efficiency Using DSO
- The Proforma Invoice and Its Value in Export Sales
- Resolving A/R Disputes
- Understanding the Balance Sheet
- Understanding the Cash Flow Statement
- Understanding the Income Statement