Types of Accounts Receivable Financing

Accounts receivable financing involves either pledging the company’s accounts receivable as collateral against a loan or selling the accounts outright.  Although hybrid forms of A/R financing exist, the basic types are asset based lending arrangements with commercial banks and factoring arrangements with specialty firms.

•         Under the terms of a commercial arrangement, a loan is made against a predetermined portion of the company’s receivables while the responsibility to collect the funds remains with the company.  The terms of such an arrangement will most likely exclude a certain portion of accounts with balances over a specified age (usually 90 days), a limitation on the percentage a single account can represent of the total receivables (probably 20% to 30%) and a limit of the loan amount to a percentage of the eligible balances (most often 70% to 85%).  Provisions and restrictions similar to those identified above will be included in the formal documents for a commercial accounts receivable loan and specific reports will be required each month to substantiate the borrowing base.  The borrowing base is the maximum amount of funding that can be advanced under the loan agreement as determined by applying the exclusions and limitations identified above.

•         Factoring arrangements represent a form of financing where the accounts are sold to a specialty firm at a discount.  Unlike a standard commercial arrangement, in most cases it is the responsibility of the lender to collect the accounts without recourse.  In other words, the factor assumes all the risk and cannot come back to you if the funds are not collected.  Also, a continuing agreement is made between your company and the factor under which it contracts to perform credit checks on customers and to purchase all of the accounts receivables as they are generated from your sales.  The factor pays the company an agreed percentage each month based on the face value of all accounts acquired and retains the difference as its compensation in the transaction.  There may be slight variations of the specific terms, but the overall theme is basically the same.  Although factoring is an expensive form of financing, it eliminates the need for a credit and collection department and, as long as the quality of the accounts is sufficient and your billing cycle is relatively short (daily or weekly), it offers a fairly stable source of financing.  Because of the cost, this form of financing should only be used when other accounts receivable financing is not available or where the cost of managing the credit and collection functions internally exceeds the fees charged by the factor.

•         Like receivables financing, inventory financing is essentially a secured, revolving loan whereby a predetermined percentage of the inventory value is advanced to the company under specific negotiated contract terms.  It is possible that the terms of such an arrangement could exclude certain inventory items from the eligible balance.  Also, because inventory is less liquid than accounts receivable, the advance rate will be lower (usually in the range of 50%).  Provisions and restrictions similar to those identified above for accounts receivable loans may also be included in the agreement for inventory loans.  Specific reports will be required each month to substantiate the inventory borrowing base.

•         It is not uncommon to have a financing agreement that combines both accounts receivable and inventory into one asset based lending contract.  Under such an arrangement, the bank would make funds available to the company on terms similar to those described above using the combined value of the accounts receivable and the inventory as the borrowing base.  All other terms and conditions are the same and would apply to each asset as would be the case for the separate individual contracts. 

DSO: The Essential Measure of Accounts Receivable Management Success

A fairly simple measure that is very useful for monitoring the effectiveness of A/R management is Days Sales Outstanding (DSO).  DSO indicates the average age of the receivables, which basically shows the average number of days it takes to collect your A/R.  The lower the DSO the more quickly you convert revenue to cash.   For example, a DSO of 45 indicates a much more effective A/R collection process than does a DSO of 65.  It’s important for you and your financial team* to regularly run “what if” scenarios to better understand the cash flow impact of an increasing or decreasing DSO. 

DSO is calculated as:

D = r / (s1 / 365)

or

D = (r / s2) x 30

where r is Accounts Receivable, s1 is the annual revenue (trailing 12 months) and s2 is the average monthly revenue.  Each formula will give you a slightly different answer because of the number of days used in each, but the difference is not significant enough to cause concern.  The reason both formulas are given here is that in some cases it is more time consuming to determine annual revenue for 12-month periods that cross over two accounting years.  Also, situations where revenue is increasing or decreasing dramatically will often cause the annual revenue number to be less representative of the average than a shorter period that corresponds more directly to the age of the A/R (maybe three or four months).  In cases where the annual revenue is easily determined and is fairly consistent it would be better to use the first formula.  However, in cases where the annual revenue is difficult to determine and/or there are significant revenue fluctuations, it would be better to use the second formula and determine the best average revenue number to use.

The industry in which your company operates will have certain conditions present that influence the ability to collect the amounts billed within a reasonable period of time.  In some businesses a DSO of 60 would be completely unacceptable where in others it would represent an excellent collection rate.  You must establish the appropriate targets for your company and maintain the consistent effort that is required to optimize the cash cycle.

*Explore your options for beefing up your financial team by visiting The Profit Experts.