March 30, 2010

Your accounts receivable are obviously worth money: just as soon as a client or customer gets around to paying his invoice, you'll have money in your hands. But in the meanwhile, those invoices are just worth the paper they're printed on. You can't spend the money that they promise you until you actually receive payment. That doesn't mean that accounts receivable can't be a source of cash in the short-term, however.

Using Accounts Receivable for Cash

Because banks and other lenders consider your company's accounts receivable to be an asset, you can use them to take out an asset-based loan with your accounts receivable as collateral. Alex Kwechansky's background in public accounting and business reorganizations has put him on both sides of the table during this sort of loan. He describes a loan based on accounts receivable:

"This loan uses the company's customers themselves as the debtors. Thus, the borrower is secondarily responsible to pay the lender. This works either by having the receivables formally secured with actual notice sent to the customers or (with better, established borrowers) being trusted to immediately repay the lender as funds are collected. As funds are collected, the access to new funds becomes conditionally available. Audits are occasionally performed to check for compliance."

With this sort of loan, you generally can borrow between 75 and 80 percent of the value of your invoices, although with the various fees and paperwork that go along with the loan, it's easy to wind up without much of the original amount of an invoice left over.

Another alternative is to work with a factor to sell your accounts receivable outright.

"Less financially stable companies can use other lenders, generally called factors, to actually buy the account receivable and to collect the funds directly," says Kwechansky. "They pay a reduced amount for the receivable but the borrower gets upfront cash and no collection delays or collection costs. They can also choose to sell one invoice at a time as they need cash than to be tied to an all in A/R commitment. Both of these accounts receivable loans have their downsides but, from my experience, they are less complicated and less encumbering than going to a bank."

Taking Out a Loan

In order to apply for and receive an asset-based loan, you can expect to hand plenty of paperwork over to a lender. Much of the list is the same if you are considering factoring your accounts receivable. That paperwork will include financial statements and tax returns for the business, so that a lender can establish the stability of the business. Depending on your business structure, you may also be asked to provide personal financial records for the owner as well.

You'll also need to hand over the paperwork on your accounts receivable, including a customer list and agings reports for either a loan or factoring. For a loan, you'll be asked for information about your inventory (not just what you already have on hand but your raw materials and how long you expect it to take to move your inventory) and your accounts payable details. Such information is necessary to establish your ability to pay back a loan.

It's important to remember that just because you apply for a loan of a certain amount, it's up to the lender to decide how much credit to extend. While some lenders will offer a loan of up to 80 percent of your accounts receivable, they may reduce the amount they make available based on the stability of your company. Some banks may also take your inventory into account when calculating a loan.

Once you've received an asset-based loan, you should expect that your lender will establish some sort of reporting requirement to insure that you are collecting your accounts receivable in a timely manner, as well as keeping your financial situation otherwise in order. Just like with a credit card, lenders can reduce the amount available to you to borrow based on a change in your business finances — that sort of situation requires you to immediately make payments to get the balance of your loan down to an acceptable level.

The Drawbacks to Loans

Marc Bowers is the co-founder of the Grun Company, which manufactures erosion control equipment. The company depends on factoring its accounts receivables for survival, but the situation isn't entirely perfect:

"Factoring is expensive. It is the equivalent of working for free; you pass a lot of margin through to the factoring agent. It has made a difference in our ability to function because it is one of our very few, and very austere, sources of production funding. If we weren't factoring right now, then we wouldn't be producing anything to sell and we would be dead in the water. Period."

There can be issues along the way when you use your accounts receivable as collateral, as well. Everything from simple paperwork issues to problems with a lender can pop up, depending on who you work with. Kwechansky routinely conducts business fraud investigations. He notes that the audits that some lenders perform can actually cause problems with a loan, even when the borrower's books are in order:

"These audits are generally performed long after the fact and can create more problems than they solve. Lenders have a habit of hiring the cheapest auditor. Often you get what you pay for."

Using your accounts receivable in order to get cash is not the best fit for every business. It is more commonly seen in businesses based on manufacturing, because the need for capital to continue production is a situation that requires capital even if invoices aren't immediately paid. But just because that is the most common situation doesn't mean that your business should or shouldn't consider the option. Instead, it means that you'll need to run the numbers for yourself and see what the benefits or drawbacks are in your individual situation.

Wise Bread is a leading personal finance community dedicated to helping people get the most out of their money. Get daily money tips by following Wise Bread on Facebook or Twitter.

Related Topics

• Money

Related keywords

Thursday Bram, Article, financial management, Wise Bread

Join the conversation ( 4 )

• Nora Dunn 2 years 1 months and 21 days ago

  

  While I believe that factoring is a great way to get extra cash and something that many business owners overlook, I can’t stress enough that actually collecting on said accounts is even more important. I’ve seen business owners go under for lack of ability to collect money from their clients and keep their accounts receivable under control. http://www.openforum.com/idea-hub/topics/money/article/accounts-receivable-nightmares-collecting-on-delinquent-accounts-nora-dunn

• Thursday Bram 2 years 1 months and 27 days ago

  

  Julie & Marc, I'm a big believer that factoring isn't right for every business, but there are plenty that will find it an ideal solution to cash flow issues. It can be difficult to decide in some cases, but sitting down and going through the numbers has never hurt anyone.

• Marc Spangenberg 2 years 1 months and 29 days ago

  

  Great article and absolutely correct in pointing out that small business has large amounts of cash tied up in Accounts Receivable (A/R). There is a cost to everything and it should be noted that there is also a cost to doing nothing. By allowing A/R to remain outstanding, the business incurs an opportunity cost to reinvest those funds in the business or even receiving interest with bank deposit. B2C merchants solve this problem by accepting credit cards realizing that the cost involved is *** compared to the convenience of getting paid faster. As consumers, we all pay a fee to access our own funds through an ATM (at least out of network) or get cash back at the grocery store.Most B2B transactions are done on a "trade credit" basis whereby the seller of goods or services generates an invoice to the buyer who pays according to the terms of the invoice. Trade Credit terms are necessary to attract business because we would all rather buy now and pay later. Large corporations use the commercial paper market to help fund daily operations and smaller businesses often turn to their bank for an asset based line of credit (good luck with that these days). Businesses large and small end up paying some sort of fee or interest cost in order to reduce their DSO (Days Sales Outstanding) and increase their cash flow in.For many of our clients, we recommend an outsourcing solution for A/R which includes credit monitoring of customers in deciding who to extend trade credit in the first place. Once a customer of our client is approved, advances can be made on invoices to that customer for a fee that is about the same as accepting a credit card. This system relieves the client from the burdens of credit decisioning, monthly account monitoring and collection so they can focus on their core business.When factoring is a better fit, we assist our clients in becoming members of The Receivables Exchange providing them with a lower cost of capital through an invoice auction process.:)

• Julie Rains 2 years 1 months and 30 days ago

  

  Excellent discussion of factoring and alternatives to factoring; many companies depend on factors or a similar situation simply due to the nature of their businesses -- their customers need time to resell or add value before paying them, and the terms are so drawn out that it makes sense from a cash-flow perspective to go ahead and get cash now. But as you point out, running the numbers (including the cost of administration and interest expenses) can be the best way to tell which method will work for your business.