Checklist Description
This checklist explains how to use receivables as collateral when dealing with a bank or other financial institution.
Definition
Receivables are money owed by customers, whether they are individuals or businesses, to another entity for goods or services that have been delivered or used, but have not yet been paid for. Receivables are usually due within a short time period, which typically ranges from a few days to a year.
Accounts receivable financing is used by companies facing short-term cash flow problems, and it can take many forms. The major source of accounts receivable financing is commercial finance companies and factoring companies, as well as banks that will consider receivables as security or collateral for a business loan. Most companies operate by allowing a portion of sales to be on credit, usually to customers that are invoiced periodically, which removes the burden of physically making payments as each transaction occurs. Credit acts as an IOU for goods or services already received or rendered and is given in good faith. Collateralizing receivables is a form of secured lending that gives companies short-term financing by selling their trade receivables or pledging receivables as collateral for a loan from a lender. Until the global financial crisis of 2008, receivables were securitized as well.
Direct sale of accounts receivable is called factoring. A loan from a bank secured or collateralized against accounts receivable is known as a discount, where the borrower draws against a line of credit that is less than the full value of the trade credits. Accounts receivable financing is a flexible way of obtaining credit, and borrowers’ financing costs are related directly to their business cycle. In a general assignment, all receivables can serve as collateral, with new receivables substituted for those collected. In a specific assignment, the parties involved can specify who will receive collection, whether customers will be notified of the arrangement, and which accounts are to be collateralized.
Accounts receivable factoring is different from using accounts receivable as loan collateral because you sell the receivables to a factor at a discount; the factor then collects the debt and you don’t have to worry about loan repayments. Accounts receivable factoring makes up about a third of all financing secured by American companies using accounts receivable and inventory as collateral.
When a loan is obtained from a bank with receivables as collateral, there are rather more formal guidelines. Banks and finance companies insist on weekly reports on sales, collections, and ineligibility analysis, as well as internally generated financial statements with detailed accounts receivable and accounts payable information. The amount borrowed is then repaid within a specified short-term period as the receivables are collected.
Advantages
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Collateralizing receivables can provide another source of working capital, freeing up essential funds for items such as payroll and taxes.
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This form of financing can provide relief from the responsibility of collection from nonpaying and slow-paying clients.
Disadvantages
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Receivables financing is often priced at spreads above the bank prime rate and is relatively expensive compared with other forms of credit, particularly factoring.
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The older the account, the less value it has.
Action Checklist
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When you sell an account to an accounts receivable factoring company, try to get a personal recommendation for the company and ensure that your accounts receivable factoring agreement states the exact conditions and charges for the purchase of your accounts receivable.
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Check the rates carefully and find out the amount a lender is willing to advance against the value of your collateralized receivables. The borrowing base is determined by multiplying the value of the assigned collateral by a discount factor, a process known as margining.
Dos and Don’ts
Do
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Set up an easy-to-check accounts receivable report.
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Have a system in place to assess monies owed and monies unpaid.
Don’t
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Don’t wait too long to take action on debts.
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Don’t fall back on sentiment and loyalty.
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Don’t forget to check bank rates, loan rates, and factoring rates.
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Don’t use accounts receivable factoring as a way to get ready cash.
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