Accounts receivable is a ledger containing information about credit sales. Each customer with a credit arrangement has an account that records credit sales dates, the original amounts, payments, and current balances. A business might wish to monetize its A/R book quickly, without waiting for payments to come in. You can do this by selling A/R invoices or using them as collateral for a loan or credit line.
The balance sheet lists accounts receivable under current assets. You may establish an allowance for doubtful accounts to reduce the net value of A/R. Customers qualify for credit sales if they meet your requirements for credit score, credit history, and other risk factors. The more lenient your credit policy, the more likely you'll encounter some deadbeats that don't pay their bills. Businesses typically consider invoices older than 90 days to be seriously delinquent -- you might turn these over to a collection agency or simply write them off.
Accounts receivable can be the basis of financing for your business. There are a few ways to do this:
1. Factoring: A merchant sells A/R invoices to a factoring company in exchange for cash.
2. Auction: The online sale of selected invoices on a receivables exchange.
3. Pledging: The merchant pledges A/R as collateral for a loan.
4. Assignment: A merchant assigns the rights to A/R to a lender but must sign a promissory note using A/R as collateral.
Accounts Receivable Factoring
A/R factoring is an option available to merchants who have a sizable A/R balance. It works like this:
- The merchant sells some portion of its A/R balance to a factoring company for roughly 80 to 85 cents on the dollar.
- As the factor collects on the A/R invoices, it forwards the remaining 15 to 20 percent of invoice value to the merchant, minus the factor's financing fee.
The factor is responsible for collections, which saves time and trouble for the merchant. Factoring is not a loan, so there is no impact on the merchant's balance sheet liabilities and no increase in leverage ratios. Approval of factoring deals is not a function of the company's credit rating, but rather its customer collection experience. Factoring is much less expensive than merchant cash advances (MCAs), and previous sales, not future ones, collateralize the money paid upfront. Factoring creates an expense equal to the factoring fee.
Accounts Receivable Auction
A/R auction is a more flexible version of factoring because you can select which A/R invoices to sell and to whom you sell them. You list the invoices for sale on an exchange website. Then, financial institutions vie with each other to purchase your invoices, possibly driving up the percentage of the invoice values you'll receive. Auctioning doesn't require you to enter into long-term contracts with factoring companies nor to sell all of your invoices. Buyers may choose to pool your invoices with those of other companies to serve as collateral for selling asset-backed securities. These securities allow investors to collect cash flows from the receivable pool.
Accounts Receivable Pledging
When A/R is the collateral, lenders allow you to borrow some A/R balance percentage, typically 80 percent. Collateral assures lenders of reimbursement if a borrower defaults on a loan. Lenders frequently require collateral in excess of the loan amount. In some cases, lenders figure the loan amount by evaluating the ages of A/R invoices and your customers' credit ratings. Pledging arrangements usually give the lender "recourse" to collect customer bad debts from you.
Disclosure of Pledged A/R
A pledged A/R book remains the property of the borrower, listed on its balance sheet. To disclose the pledge, you may add a parenthetical comment on the balance sheet stating the amount pledged and the amount excluded because of the allowance for doubtful accounts. Alternatively, you can give the same information in the notes to the balance sheet. You should also add a note to the bank loan payable entry in the balance sheet's liabilities section, stating that pledged A/R collateralizes the loan.
To make the costs of the pledging arrangement transparent, you can create expense accounts dedicated to the interest payments and the fees of the collateralized loans. In this way, investors have a better picture of the pledge agreement's total economic cost and benefits. You usually do not inform customers that you've pledged their accounts. When you collect payments, you forward them to the lender and reduce loans payable accordingly. You might have a revolving agreement in which a lender adjusts a line of credit when the outstanding A/R balance changes.
Accounts Receivable Assignment
A/R assignment is a blend of pledging and factoring. You assign your invoices to a bank or other financial company and receive a cash advance based on the A/R book's discounted value. You also sign a promissory note in which the A/R serves as collateral. You must pay interest and fees to the lender. You, not the lender, continue to collect the A/R invoices, but you forward these collections to the lender. This is a recourse loan requiring you to reimburse the lender if any of your customers default on A/R invoices. You handle financial reporting of the A/R assignment as you would for A/R pledging.
A/R Financing vs. Merchant Cash Advances (MCAs)
MCAs are lump sum payments collateralized by future credit card and debit card sales. The borrower receives a fixed amount upfront and then a percentage of future card-based sale revenues. The total benefit experienced by the borrower is usually less than that available from factoring transactions.
The split of future card revenues is determined by the factor rate or buy rate. For example, imagine a company selling $50,000 of its future card sales in a 12-month MCA transaction. If the factor rate is 1.5, the borrower will have to pay back 1.5 x $50,000, or $75,000 over the next 12 months to avoid default. All the interest is charged upfront rather than accruing over the life of the advance.
As you can see, MCAs are much more expensive than A/R factoring and carry with them the risk of default, which can lead to the need to serially renew MCA agreement, making it a risky form of business financing. Failure to meet the payback terms can lead to bankruptcy proceedings.