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.