Unlocking Financing with your Accounts Receivables

When businesses make a sale, you would expect customers to pay off the invoice immediately.

Unfortunately, 95% of customers prefer not to pay upfront.

Because of this, businesses provide credit terms with flexible payment methods to enhance customer experience and drive further B2B sales. Typically, credit terms range between 15-30 days.

But here is the problem.

As the business scales, maintaining adequate cash flow becomes a challenge because money from the additional sales are all tied up within the accounts receivables waiting to be collected.

This delay in collecting funds can impede day-to-day operations, hamper growth initiatives, and limit opportunities for expansion.

To address this cash gap, many businesses turn to accounts receivable financing.

Accounts receivable financing, also known as trade receivables financing or AR financing, is a short-term funding solution that provides businesses with access to a portion of their outstanding accounts receivable.

Essentially, it allows businesses to convert unpaid invoices into immediate cash through a lending arrangement.

In this issue, I will be sharing the typical AR financing arrangements, common problems that reduces financing capacity, and how to get around these problems.

Let’s dive in!

Typical AR Financing Arrangements

The most common AR financing arrangement used by banks is a form of Asset Based Lending (ABL).

ABL uses accounts receivable as collateral to secure a line of credit. Banks will extend financing against a percentage of the eligible receivables. This arrangement allows businesses to draw funds as needed and pay interest only on the borrowed amount.

Here’s a simple example.

Each month, a company provides their aged accounts receivables listing to the bank. This month, the company reported $1,000,000 in outstanding eligible AR. Based on the loan agreement, the bank will finance 75% of the eligible AR. This means the company has access to financing up to $750,000 until the next round of financial reporting is due.

In some cases, if your customers include government entities or blue chip companies, these companies are seen to have undoubted credit rating. This lowers the risk of bad debt and gives the bank comfort to potential increase their loan to value up to 80-85% of AR.

The company can now use this dry powder to finance their operations and other growth initiatives. Once the outstanding ARs are collected, the cash received is used to repay the line of credit.

Since a company’s AR balance is fluid, the amount of financing available will fluctuate each month based on the amount of AR reported at the end of each reporting cycle.

Common Problems that Reduces AR Financing

Unfortunately, things in life are never that simple. Notice how I’ve used the word “eligible” accounts receivables above? You can probably guess where this is going. There are problems that can void the eligibility of your AR. Here are some common problems:

Stale Accounts Receivables

Stale AR are receivables that have been outstanding for over 90 days.

Banks monitor the health of a company’s AR listing based on the proportion of AR due within 30, 60, 90, and 90+ days. The company should have the most receivables due within 30 days and reduces as it gets to 60 days, 90 days, and beyond.

Statistically, the longer the receivable is outstanding, the less likely it is for the company to successfully collect the receivable.

This is a risk to the bank because if the bank needed to liquidate the company’s assets, it will be highly unlikely to recover the sales proceeds from 90+ days ago. To mitigate against this risk, all AR outstanding for over 90 days becomes ineligible.

Historical Bad Debts

Bad debts are accounts receivables that are written off because they are no longer collectable. This is a further extension of the stale receivables problem above.

If a company has a consistent history of writing off bad debt, this is a clear sign that the company either has collection issues or they are selling to customers who are not creditworthy.

When banks finance against AR, they need to ensure that they can reliably collect on the receivables outstanding. When the AR turns into bad debt, there will not be any money to repay the loan.

In this scenario, the bank will apply a block to reduce the amount of eligible AR for financing or reduce the loan to value from 75% to 65%, protecting itself from potential write offs.

Intercompany / Related Party Receivables

Intercompany or related party receivables are created from transactions to non-arm’s length parties.

Typically, these would involve multiple companies who share common ownership or close (blood) relationship. For example, John Smith has a company that sells boxes and a company that sells shoes. When the shoe company buys boxes from the related company, this creates a related party receivable at the box store.

Since a relationship exists between entities or persons, if the bank were to liquidate the company’s assets, it’s highly unlikely that the related party will pay the outstanding balance on the invoice.

While the receivable is legally enforceable, from a practical collection perspective, this is not the case. As such, all intercompany / related party receivables are treated as ineligible.

Same Name Obligations

Same name obligations refers to the scenario where the company’s customer is also vendor to the company.

An example of this scenario is a paint company selling products to a painter. When the paint company receives a job order to paint a fence, they will outsource the job to the painter to complete jobs to paint fences. In this scenario, the paint company creates a receivable owed by the painter. At the same time, the paint company creates an accounts payable as an obligation to pay the painter for the fence job.

When the bank is considering AR financing for the paint company, there is a hidden risk that the painter can dispute the AR outstanding if the paint company has not settled on the obligations to the painter. This can potentially reduce the collectable amount on the current AR by offsetting the amount of the payable.

To mitigate this risk, banks will consider all outstanding obligations to the vendor as a deduction to the current accounts receivable for eligibility.

For example, if the paint company has a receivable for $30,000 and a payable for $20,000, the net eligible receivable for financing will be $10,000.

Customer Concentration

Customer concentration occurs when a single (or few) customers account for a significant portion of the company’s sales. When a business is overly reliant on a small group of customers, there can be volatility of the company’s income. Losing one customer can be a big reduction of revenue and cash flow, which reduces the company’s ability to repay the loans outstanding.

Banks will typically scrub through your company’s AR listing over several periods of the year to look for customer concentration. If the bank doesn’t feel comfortable with the level of customer concentration, they may limit the amount of total eligible AR for that particular customer. This means any additional sale above a threshold will not provide any benefit for financing.

Customer Deposits

A customer deposit is money paid by the customer before the company has earned it. Common examples of this include paying a deposit to secure significant inventory or equipment purchases.

When a customer has put a deposit on your books, you have already benefited from receiving that cash. This cash is free for you to use. When the sale is completed (i.e. equipment has been built and delivered), the AR from the sale should reflect the net amount of the sale.

When banks review AR samples for financing, they run checks against the purchase orders and invoices to see if the corresponding AR matches the remaining amount owed. If the AR is overinflated because it includes the deposit held, the bank will deduct the value of the deposit from eligible AR. This prevents against double financing from cash that has already been received.

Builder’s Lien

Since payment disputes on construction projects are extremely common, a builder’s lien is a holdback of accounts receivable on each progress payment of a project related to the value of labour and materials applied on a project. The builder’s lien is used to protect sub-contractors to ensure they are paid their portion of work completed on the project. This holdback is also known as a construction lien or retainage”.

If a subcontractor, supplier or worker working for you has not been paid, they may have the right to file a lien against the project property. This affects the property owner’s ability to sell or finance the ongoing construction of the project.

This lien is applicable typically to companies in the construction industry, where financing against accounts receivables becomes tricky. Since builder liens rank ahead of the bank’s interest in the event of liquidation, the bank will deduct the amount of holdback against your eligible AR.

How to get around these problems

As you can see, there are a lot of nuances to financing against receivables. Since there are so many types of business and possible sales arrangements, its very important to understand all the risks in your company’s sales cycle, from the initial sales process all the way through to the final receipt of cash.

In almost all of the common problems outlined above, the best way to preserve the eligibility of AR for financing is to avoid these problems (i.e. same name obligations and related party receivables).

For example, if your receivables are taking too long to collect, review your collections process to ensure that receivables are collected on time. 3 ways to speed up AR collection include (1) withholding further shipment of goods until past invoices have been cleared, (2) putting the customer back on cash on delivery, or (3) offering a small discount for invoices to be paid prior to its due date. Alternatively, the quality of receivables can be improved by first reviewing the creditworthiness of the customer before providing credit terms.

If the company’s sales is concentrated to a few key customers, create a plan to diversify sales to more customers to reduce the amount of concentrated exposure. Alternatively, you can explore the option to purchase accounts receivable insurance (aka trade creditor insurance), which protects the company against disputes or non-payment of receivables. This will alleviate the bank’s concerns because there is a much greater certainty of collection. AR insurance also adds an additional benefit; banks are willing to finance higher loan to values on insured receivables.

For companies that collect customer deposits, there is no disadvantage to taking customer deposits. In fact, the company is benefiting 100% from the receipt of deposits that can be used to fund the remainder of the sale. Alternatively, AR financing will never finance 100%.

For companies with builder’s liens, this is normal business practice within the industry. A contractor/sub-contractor should ensure there is adequate cash and equity in the company prior to engaging a large construction project.

Summary

Financing against receivables is one of the best ways to unlock cash flow into your business.

By taking advantage of early access to cash, the company can use the funds to invest and grow into additional sales cycles throughout the year, allowing it to scale.

Despite the intricacies of each business, there are nuances that reduce the amount of eligible financing.

It’s a smart idea to understand the risks that banks are looking to mitigate because these same risks can impact your business.

There are usually a variety of ways to mitigate against these risks to build a healthier book of receivables.

This all rolls back up to the top because healthier receivables leads to higher percentage of receivables collected, which leads to more cash to grow, which leads to more sales and AR, which ultimately leads to more financing capacity.

That’s all for today. See you next week.

Cheers!

Lawrence

That's it for this week. Thank you for reading Financing Journey. See you next Saturday.

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