Fundamentals of Financial Management: An Analysis (part 25)

“Time is more value than money. You can get more money, but you cannot get more time.” – Jim Rohn

Sources of Short-Term Financing (Part D)

by

Charles Lamson

Accounts Receivable Financing

Accounts receivable financing may include pledging accounts receivable as collateral for a loan or an outright sale (factoring) of receivables. Receivables financing is popular because it permits borrowing to be tied directly to the level of asset expansion at any point in time. As the level of accounts receivable goes up, a firm is able to borrow more.

A drawback is that this is a relatively expensive method of acquiring funds, so it must be carefully compared to other forms of credit. Accounts receivable represent one of the firm's most valuable short-term assets, and they should be committed only where the appropriate circumstances exist. An ill-advised accounts receivable financing plan may exclude the firm from a less expensive bank term loan.

Pledging Accounts Receivable

The lending institution will generally stipulate which of the accounts receivable is of sufficient quality to serve as collateral for a loan. On this basis, we may borrow 60 to 90 percent of the value of the acceptable collateral. The loan percentage will depend on the financial strength of the borrowing firm and on the creditworthiness of its accounts. The lender will have full recourse against the borrower if any of the accounts go bad. The interest rate in a receivables borrowing arrangement is generally well in excess of the prime rate.

The interest is computed against the loan balance outstanding, a figure that may change quite frequently, as indicated in Table 2. In the illustration, interest is assumed to be 12 percent annually, or 1 percent per month. In month 1, we are able to borrow $8,000 against $10,000 in acceptable receivables and we must pay $80 in interest. Similar values are developed for succeeding months.

Factoring Receivables

When we factor receivables, they are sold outright to the finance company. Our customers may be instructed to remit the proceeds directly to the purchaser of the account. The factoring firm generally does not have recourse against the seller of the receivables. As a matter of practice, the finance company may do part or all of the credit analysis directly to ensure the quality of the accounts. As a potential sale is being made, the factoring firm may give immediate feedback to the seller on whether the account will be purchased.

When the factoring firm accepts an account, it may forward funds immediately to the seller, in anticipation of receiving payment 30 days later as part of the normal billing process. The factoring firm is not only absorbing risk, but also is actually advancing funds to the seller a month earlier than the seller would normally receive them.

For taking the risk, the factoring firm is generally paid on a fee or commission basis equal to 1 to 3 percent of the invoices accepted. In addition, it is paid a licensing rate for advancing the funds early. If $100,000 a month is processed at a 1 percent commission and a 12 percent annual borrowing rate, the total effective cost will be 24 percent on an annual basis.

If one considers that the firm selling the accounts is transferring risk as well as receiving funds early, which may allow it to take cash discounts, the rate may not be considered exorbitant. Also the firm is able to pass on much of the credit checking cost to the factor.

Asset-Backed Public Offerings

Asset-backed securities are nothing more than the sale of receivables. Asset-backed public offerings are popular, and IBM has added a new wrinkle by selling a public offering of receivables due from state and municipal governments. The interest paid to the owners of these securities is not taxable by the federal government. This allows IBM to raise cash at below-market rates. This strategy may be available only to large companies having significant business with state and local government units. Investment bankers continue to develop new types of asset-backed securities, and they are optimistic that the use of all asset-backed securities will continue to grow because of the predictable cash flows they offer investors.

One of the benefits of the issuer is that they trade future cash flows for immediate cash. The asset-backed security is likely to carry a high credit rating of AA or better, even when the issuing firm may have a low credit rating. This allows the issuing firm to acquire long cost funds than it could with a bank loan or a bond offering. This short-term market can provide an important avenue for corporate liquidity and short-term financing.

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 222-225*

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