Accounts Receivable Financing (#321)

What is Accounts Receivable Financing?

The topic of this episode is to describe how accounts receivable financing works. Under receivables financing, a business uses its accounts receivable as collateral for a short-term loan. The loan has to be short-term, because the duration of the loan needs to match the underlying collateral, which is the accounts receivable. A business can essentially extend the term of the loan by constantly creating a new set of accounts receivable that then becomes the collateral on the loan as the earlier receivables are paid by customers. So, as long as the company can sustain the amount of receivables outstanding, it can keep borrowing about the same amount of money from the lender.

 A business uses accounts receivable financing when it needs cash sooner than the receivable payment terms. For example, if you need cash in five days, but the invoice payment terms are 30 days, then you have a problem. In this case, the loan from accounts receivable financing is intended to essentially accelerate the receipt of cash from the receivables.

Understanding Accounts Receivable Financing

 There are two ways in which accounts receivable financing can be set up. Under the first approach, the lender advances a percentage of the receivables balance to the borrower, and commits to collect the receivables. The lender monitors all receivables due from customers, and has payments sent to the lender’s designated location, which is usually a bank lock box.

 The amount loaned will be less than the amount of the receivables being used as collateral, possibly as much as 90% of their face value. When customers send their payments to the lender, it extracts the amount of its loan and any associated fees and interest charges, and then forwards the residual amount to the borrower.

 Since the lender is involved in collection activities, it may cherry pick which customer invoices it will include in the borrowing arrangement. That means it only takes invoices issued to the highest-quality customers, and probably only for larger amounts. This makes it more efficient for the lender to collect the invoices.

  Under this approach, it’s in the best interests of the lender to have customers send all accounts receivable payments directly to it, bypassing the borrower, so that it can be assured of being paid. This is not a small issue, since companies using receivables financing may be having financial problems, and could go under. If they do go bankrupt, the lender still has the accounts receivable as collateral, but it may take quite a while to extract its money from the bankrupt business.

 The problem for the borrower is that having customers send their payments to a new address gives customers the impression that the business is on a shaky financing footing – which might very well be the case – so they may be inclined to buy from someone else in the future. So in short, there’s an inherent tension between the lender and borrower about where the customer payments should go.

 The second approach to receivables financing is for the receivables to essentially be used as collateral on a cash advance from the lender, but where the borrower maintains control over the receivables and collects from customers. This approach is least visible to customers, so it favors the borrower.

The Cost of Accounts Receivable Financing

 There’s obviously a lot of paperwork associated with receivables financing, so lenders charge a pretty high interest rate. In addition, they charge an upfront fee to reimburse their underwriting and origination expenses. This fee can increase in size if the arrangement is a large or complex one. And on top of that, the borrower has to pay a processing fee every time a customer pays an invoice, which might be calculated as a percentage of the face amount of the invoice. Individual lenders have different rate structures, usually because they’re trying to attract different types of customers. So, it makes sense to shop around.

 All in all, this one of the more expensive financing options. Lenders claim that this is because the cost of administering these loans is unusually high, but I don’t buy it. If you check the cost per click for a Google ad for “accounts receivable financing,” it’s $70 – per click. The cost per click for “receivable financing” is $75. And the cost per click for “receivable factoring” is $80. When lenders are willing to pay that much for one lousy click on one of their ads, that tells me that plenty of profits are being made.

 So, why on earth would anyone pay these fees? Because they have nowhere else to go. Businesses that use receivable financing have been turned down by traditional lenders, probably because they’re not profitable or they don’t have any other collateral, or the founders don’t want to back up a loan with a personal guarantee.

 Because of the high fees, it makes no sense to use this type of financing if your margins are already low – the fees will just eat up your profits, and then you’ll go out of business.

When to Use Accounts Receivable Financing

That being said, there are a couple of situations in which it makes sense to use it. The first case is when a business has very little cash but is growing fast. It needs to finance an expanding amount of receivables, but doesn’t have the cash to pay for the underlying inventory. In this situation, use receivables financing as long as sales are going up fast, and stop using it as soon as sales level out.

 The other situation where it can make sense is when the company’s invoice terms are really long. This usually happens when a small company is forced by a large customer, such as a retail chain, to accept long payment terms, like 90 days. In this case, the business uses the receivables as collateral to get an immediate cash loan from the lender.

 There are a couple of lesser advantages to receivables financing. One is that you can qualify for financing a lot quicker than a typical bank loan, so if you need cash now, this is a good way to go. The other reason is that, if the lender is taking on the task of collecting receivables, the borrower can cut back on its own collection activities.

How to Apply for Accounts Receivable Financing

 So, let’s say you want to proceed with a receivables financing arrangement. The first step is to create a cash forecast for the next few months, to estimate the size of your shortfall. Next, review your list of outstanding invoices, and strip out any for which the probability of collection is low. The remaining invoices will be reviewed by the lenders. Then, assemble the company’s most recent bank statements and tax returns, as well as its business license, because the lenders will want to review this information as part of their credit analysis. After that, it will take a couple of weeks for them 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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