Accounts Receivable Financing

Every business. At some point in time, and for a variety of reasons, needs to get hold of additional working capital. You may be planning to develop or launch a new product, open a new branch, upgrade equipment, or restructure your debt.

Most people would immediately think of the traditional loan from a bank. After all, this is how business funding has been obtained since time immemorial. In order to remain competitive, lending institutions constantly strive to develop alternative financing mechanisms to meet the ever-changing needs of their customers.

Changing lending criteria

The business landscape has changed a lot over the last few decades. Business failures often result in lenders having to write off large debts to the detriment of their investors. Consequently, they have become far more conservative in their risk assessment and appetite. It has, therefore, become more difficult to get access to financing. This is particularly so for businesses that have weaker credit records or balance sheets. 

Fortunately, one of the alternative financing models that has arisen from these developments is the accounts receivable loan.  

What is accounts receivable financing?

Rather than obtaining a traditional loan, a business can secure funding by offering their accounts receivable as collateral. Traditionally, loans are secured through business assets or guarantees of owners or shareholders. In rare cases, businesses with strong balance sheets and impeccable credit histories may be granted unsecured loans.

An accounts receivable loan is different. It is based on the premise that the borrower’s customer invoices are the lender’s security. This type of borrowing is referred to as factoring and the lender is known as the factor.   

How it works

There are six basic steps to securing an accounts receivable loan.

• Firstly, a business would approach a factor to apply for the financing and offer the accounts receivable list. The borrower may offer the entire list or they may select a specific category or selection of the accounts receivable.
• The factor would review the offered accounts receivable and perform an assessment of the quality of the debtors. The criteria they take into consideration may include the debtor’s credit standing as well has his payment history with the borrower.
• Based on this assessment the factor will calculate the percentage of the value of the outstanding invoices that they are willing to advance. Typically, this varies anywhere between 80% and 100% of the face value of the debtors’ book. The amount retained by the factor is called the factoring fee.
• The borrower notifies the relevant customers that the outstanding invoices have been handed over to a factor and that payment should be remitted directly to the factor.

Recourse or not?

Accounts receivable financing is predominantly done on a recourse basis. This means that the borrower retains the risk. If a customer fails to pay a factored invoice within an agreed time frame, the borrower is obliged to buy the invoice back.

The amount the borrower has to pay for the invoice would usually be the face value plus an additional fee. This surcharge is usually based on the time value of money. It is, essentially, the interest the factor would have charged on a cash advance repayable in full at the end of the period that the invoice had been advanced by the factor.

With recourse factoring, the factor does not assume the monetary risk. This is then, in reality, a case of the borrower discounting their future cash inflows in order to receive the funds sooner. The factor therefore, prices the factoring fee in accordance with the cost of capital and the return that they could have earned on the money through other investment options.

Sometimes a factor may agree to buy the accounts receivable without recourse. Here, the factor assumes the financial risk of the debtor not paying the invoice. The factor’s financial risk is directly tied to the debtor’s ability to repay the invoice within the terms agreed with the borrower.

The assessment will be far more stringent and each debtor will be vetted individually. The amount that the factor advances to the borrower is, invariably, a lower percentage of the face value than with recourse factoring. In this instance, the factoring fee includes a provision for the invoices that may be written off due to non-payment.

Benefits of factoring

 Whether a business factors its accounts receivable with recourse or without, it remains an effective way to obtain working capital. There are several distinct benefits to the borrower when compared with other financing options.

• Unlike a traditional loan, there is no fixed repayment. As long as all customers continue to pay the invoices, the borrower does not have any outflow of funds related to the financing.
• No assets are tied up as security and owners or shareholders are not required to provide personal guarantees.
• Apart from the factoring fee, there are no other consequential costs such as credit insurance or guarantee fees.
• Factoring is available to businesses that may not qualify for a traditional loan. These would include:
  • Companies that have not yet been in business long enough to have built up a good credit record,
  • Companies with an adverse credit rating, and
  • Companies whose financial position is considered a risk for the amount of finance being sought.
• Some factors will take over some or all of the debt collection function from the borrower. This reduces the administrative workload for the borrower. In some instances, the accounts receivable function of the borrower can be reduced or even eliminated. The savings achieved can, at least partially, offset the factoring fees.

Eligibility criteria

Factors may apply any combination of criteria when assessing an applicant’s eligibility for an accounts receivable loan. Criteria that may be applied include:

• The applicant must be an incorporated business entity,
• The accounts receivable must be commercial or governmental entities,
• The customers must have good credit standing and pay their invoices in accordance with the agreed credit terms,
• Invoices may not be subject to any commercial liens or encumbrances of any nature,
• Your sales revenue exceeds a certain threshold that may vary from one factor to another.

Summary

If you’re in need of financing and you’re concerned that you may have difficulty raising a traditional loan, or if you wish to secure funds with little or no strings attached, then accounts receivable financing is the way to go.