Accounts receivable are one of the most commonly used forms of collateral for secured shortterm borrowing. From the lender’s standpoint, accounts receivable represent a desirable form of collateral, because they are relatively liquid and their value is relatively easy to recover if the borrower becomes insolvent. In addition, accounts receivable involve documents representing customer obligations rather than cumbersome physical assets. Offsetting these advantages, however, are potential difficulties. One disadvantage is that the borrower may attempt to defraud the lender by pledging nonexistent accounts.
Also, the recovery process in the event of insolvency may be hampered if the customer who owes the receivables returns the merchandise or files a claim alleging that the merchandise is defective. Finally, the administrative costs of processing the receivables can be high, particularly when a firm has a large number of invoices involving small dollar amounts. Nevertheless, many companies use accounts receivable as collateral for short-term financing by either pledging their receivables or factoring them.
Pledging Accounts Receivable
The pledging process begins with a loan agreement specifying the procedures and terms under which the lender will advance funds to the firm.When pledging accounts receivable, the firm retains title to the receivables and continues to carry them on its balance sheet.
However, the pledged status of the firm’s receivables should be disclosed in a footnote to the financial statements. (Pledging is an accepted business practice, particularly with smaller businesses.) A firm that has pledged receivables as collateral is required to repay the loan, even if it is unable to collect the pledged receivables. In other words, the borrower assumes the default risk, and the lender has recourse back to the borrower. Both commercial banks and finance companies make loans secured by accounts receivable.
Once the pledging agreement has been established, the firm periodically sends the lender a group of invoices along with the loan request. Upon receipt of the customer invoices, the lender investigates the creditworthiness of the accounts to determine which are acceptable as collateral. The percentage of funds that the lender will advance against the collateral depends on the quality of the receivables and the company’s financial position. The percentage normally ranges from 50 to 80 percent of the face amount of the receivables pledged. The company is then required to sign a promissory note and a security agreement, after which it receives the funds from the lender.
Most receivables loans are made on a nonnotification basis, which means the customer is not notified that the receivable has been pledged by the firm. The customer continues to make payments directly to the firm. To protect itself against possible fraud, the lender usually requires the firm to forward all customer payments in the form in which they are received. In addition, the borrower is usually subject to a periodic audit to ensure the integrity of its receivables and payments. Receivables that remain unpaid for 60 days or so must usually be replaced by the borrower.
The customer payments are used to reduce the loan balance and eventually repay the loan. Receivables loans can be a continuous source of financing for a company, however, provided that new receivables are pledged to the lender as existing accounts are collected. By periodically sending the lender new receivables, the company can maintain its collateral base and obtain a relatively constant amount of financing. Receivables loans can be an attractive source of financing for a company that does not have access to unsecured credit. As the company grows and its level of receivables increases, it can normally obtain larger receivables loans fairly easily. And, unlike line of credit agreements, receivables loans usually do not have compensating balance or “cleanup” provisions.
The annual financing cost of a loan in which receivables are pledged as collateral includes both the interest expense on the unpaid balance of the loan and the service fees charged for processing the receivables. Typically, the interest rate ranges from 2 to 5 percentage points over the prime rate, and service fees are approximately 1 to 2 percent of the amount of the pledged receivables. The services performed by the lender under a pledging agreement can include credit checking, keeping records of the pledged accounts and collections, and monitoring the agreement. This type of financing can be quite expensive for the firm.
The following example illustrates the calculation of the annual financing cost of an accounts receivable loan: Port City Plastics Corporation is considering pledging its receivables to finance a needed increase in working capital. Its commercial bank will lend 75 percent of the pledged receivables at 2 percentage points above the prime rate, which is currently 10 percent. In addition, the bank charges a service fee equal to 1 percent of the pledged receivables. Both interest payments and the service fee are payable at the end of each borrowing period. Port City’s average collection period is 45 days, and it has receivables totaling $2 million that the bank has indicated are acceptable as collateral. As shown in Table 16.6, the annual financing cost for the pledged receivables is 22.8 percent.
Factoring Accounts Receivable
Factoring receivables involves the outright sale of the firm’s receivables to a financial institution known as a factor. A number of so-called old-line factors, in addition to some commercial banks and finance companies (asset-based lenders), are engaged in factoring receivables.When receivables are factored, title to them is transferred to the factor, and the receivables no longer appear on the firm’s balance sheet. Traditionally, the use of factoring was confined primarily to the apparel, furniture, and textile industries. In other industries, the factoring of receivables was considered an indication of poor financial health. Today, factoring seems to be gaining increased acceptance in other industries.
The factoring process begins with an agreement that specifies the procedures for factoring the receivables and the terms under which the factor will advance funds to the firm. Under the normal factoring arrangement, the firm sends the customer order to the factor for credit checking and approval before filling it. The factor maintains a credit department to perform the credit checking and collection functions. Once the factor decides that the customer is an acceptable risk and agrees to purchase the receivable, the firm ships the order to the customer. The customer is usually notified that its account has been sold and is instructed to make payments directly to the factor.
Cost of Pledging Receivables for Port City
Most factoring of receivables is done on a nonrecourse basis; in other words, the factor assumes the risk of default.26 If the factor refuses to purchase a given receivable, the firm still can ship the order to the customer and assume the default risk itself, but this receivable does not provide any collateral for additional credit.
In the typical factoring agreement, the firm receives payment from the factor at the normal collection or due date of the factored accounts; this is called maturity factoring. If the firm wants to receive the funds prior to this date, it can usually obtain an advance from the factor; this is referred to as advance factoring. Therefore, in addition to credit checking, collecting receivables, and bearing default risk, the factor also performs a lending function and assesses specific charges for each service provided. The maximum advance the firm can obtain from the factor is limited to the amount of factored receivables less the factoring commission, interest expense, and reserve that the factor withholds to cover any returns or allowances by customers. The reserve is usually 5 to 10 percent of the factored receivables and is paid to the firm after the factor collects the receivables.
The factor charges a factoring commission, or service fee, of 1 to 3 percent of the factored receivables to cover the costs of credit checking, collection, and bad-debt losses. The rate charged depends on the total volume of the receivables, the size of the individual receivables, and the default risk involved. The factor normally charges an interest rate of 2 to 5 percentage points over the prime rate on advances to the firm. These costs are somewhat offset by a number of internal savings that a business can realize through factoring its receivables. A company that factors all its receivables does not need a credit department and does not have to incur the administrative and clerical costs of credit investigation and collection or the losses on uncollected accounts.
In addition, the factor may be able to control losses better than a credit department in a small- or medium-size company due to its greater experience in credit evaluation. Thus, although factoring receivables may be a more costly form of credit than unsecured borrowing, the net cost may be below the stated factoring commission and interest rates because of credit department and bad-debt loss savings. For example, the Masterson Apparel Company is considering an advance factoring agreement because of its weak financial position and because of the large degree of credit risk inherent in its business. The company primarily sells large quantities of apparel to a relatively small number of retailers, and if even one retailer does not pay, the company could experience severe cash flow problems. By factoring, Masterson transfers the credit risk to the factor, Partners Credit Corporation, an asset-based lender.
Partners requires a 10 percent reserve for returns and allowances, charges a 2 percent factoring commission, and will advance Masterson funds at an annual interest rate of 4 percentage points over prime.Assume the prime rate is 10 percent. Factoring receivables will allow the company to eliminate its credit department and save about $2,000 a month in administrative and clerical costs. Factoring will also eliminate baddebt losses, which average about $6,000 a month.Masterson’s average collection period is 60 days, and its average level of receivables is $1 million. In, the amount of funds Masterson can borrow from the factor and the annual financing cost of these funds are calculated. As the table shows, Masterson can obtain an advance of $859,748, and the annual financing cost is 28.5 percent before considering cost savings and elimination of bad-debt losses. After considering credit department savings and reductions in bad-debt losses, the annual financing cost drops to 17.2 percent.
Masterson can compare the cost of this factoring arrangement with the cost of other sources of funds in deciding whether or not to factor its receivables. This example calculates the factoring cost for a single 60-day period. In practice, if Masterson did enter into a factoring agreement, the agreement would most likely become a continuous procedure.