Position Your AR to Enhance Working Capital
Are Your Accounts Receivables Providing Optimal Collateral Value?
Accounts Receivable (AR) reflect a promise of payment at a future date. Though a paper asset, AR competes with Property, Plant and Equipment as well as Inventory for being the largest line item on a company’s balance sheet. As such, AR is an extremely valuable component of every firm’s working capital and a major source of collateral.
Moreover, are you aware that you can convert an individual Account Receivable into cash, and receive payment just a few days after you have completed the sale and issued an invoice? You don’t have to wait until the payment terms mature — or longer for customers who pay late.
How is this done?
There are a variety of ways to collateralize receivables. If somebody mentions pledging your receivables, securitization, invoice finance, factoring, or purchasing receivables, they are referring to different means of collateralizing your AR. In determining the cost/benefit of any collateralization program, you must factor in the differences presented by each type of program, which include:
Who owns the AR — is it sold or pledged as security?
Who absorbs any potential bad debt loss — does the lender have recourse to return the AR if they cannot collect it versus a non-recourse arrangement?
Who performs the Credit & Collection activities — you or the finance company?
The interest rate, service fees or discount offered — also are you being paid a percentage of the AR upfront with the balance remitted less fees when collected.
Is your receivable from a small private company, a public company, or privately held firm that has accessed the capital markets and and had their bonds rated?
A common approach is to pledge a company’s AR as collateral to secure a loan whose funds are advanced shortly after you submit the necessary documentation confirming the AR’s creation, often an invoice and bill of lading. These loans can be a line of credit (in which case availability under the line is updated monthly) or a fixed term loan. Both types are backed by your receivables and commonly referred to as asset backed loans (ABL), Or the mechanism can be an advance on individual invoices via invoice factoring, invoice discounting or other supply chain finance methodologies. AR financing options are offered by various institutions, including banks and other financial services firms that specialize in receivables finance.
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What Determines How Much Your AR Will Yield?
To a lender, collateral is not as good as money in the bank. Instead, collateral is a hedge — something to fall back on. That is why lenders will only advance a portion of the collateral’s book value. Lenders base the amount of cash they will advance and the fees they will charge on two key factors:
Credit Risk of the AR - As noted above, who is paying the invoice is critical. If most of the AR is owed by financially strong companies with a track record of on-time payment, a lender will advance a higher percentage of the pledged AR (up to 85 percent for a line of credit). If not, the lender may advance only 60 or 70 percent based primarily on your company’s credit worthiness. Also, the older a receivable, the less likelihood it will be collected in full, or at all. Lenders will generally exclude everything owed by a customer from their collateral calculation, if any invoices from that customer are more than 60 or 90 days past due. Your AR portfolio might only have 2% in the over 90 day past due bucket, but that could cause over 10% of your AR balance to be unsuitable as collateral. Also, if you’ve been given an advance and the receivable is not paid in 60 or 90 days, you may have to pay back the advance if the financing was done with recourse.
AR Dilution - This refers to how many cents of every dollar of AR will ultimately be collected. For example, even though you have billed a customer $100, the customer may not pay $100. If your invoice price is higher than what the customer agreed to, they will pay a lesser amount. If you billed for the delivery of 50 units, but only delivered 48, the customer will pay short. If you charged shipping costs, but your agreement is to bill a “delivered” price, the customer will deduct the freight from the face amount of the invoice. Lenders will reduce the amount advanced to you based on their estimate of your “AR Dilution” rate. This will be based on your recent AR Dilution history and historic industry dilution rates.
What Can You Do to Increase the Yield?
In terms of your own company’s credit, it helps to have a strong Balance Sheet and Profit & Loss Statement that show positive cash flow, profitable operations, and sufficient leverage (ability to take on debt). Anything you do to improve your balance sheet will improve your borrowing capacity, but this artilce is focused exclusively on accounts receivable. Here’s what you need to do to get full collateral value from your AR:
1. Clean up your AR Ledger
In a perfect world, your AR Ledger would contain only whole, current invoices. No seriously past due invoices and no “Clutter.” This is a perfect state that you’ll probably never see, but the idea is to get as close to it as possible. Clutter is identified as short payments (payment deductions), debit memos, unapplied credit memos, unapplied cash, late payment fees, and unearned prompt payment discounts — typically small unreconciled open items. Ideally, 3 to 6 months in advance of actually collateralizing your AR, you should take these two actions to ensure your AR is in the best shape possible:
Launch a collection program to collect all past due invoices over 15 days late. First focus on the “problem” accounts with significant past due as well as any other accounts that have aged over 60 days past due. Refer these accounts to a Collection Agency without delay if your attempts are ineffective over the next 30 to 60 days. Then transfer any such accounts from your primary AR ledger to a subsidiary ledger reserved just for Collection Agency accounts. Click here for more details about working with Collection Agencies.
Clean up the junk. Make a concerted effort to clear off as many of the clutter transactions as possible from your AR ledger. Match unapplied payments and unapplied credit memos to open invoices, deductions, and debit memos. If any credit balances remain, ask your customer to apply them to their next invoice. Do not match unapplied credits with open deductions and debits unless there is documentation to relate them. Otherwise, you will violate escheatment laws — those credits are your customers’ property. Write off the older, smaller deductions, debit memos, and even small invoices if it would cost more to try and collect them. All this can require substantial effort, so clear the easy ones first and then work your way back through the ledger to take care of the tougher issues.
2. Reduce the Dilution Factor of Your AR
This is done a couple of ways. The first is to eliminate the factors that cause dilution in addition to cleaning up as much as possible the items in your AR that involve payment deductions and disputes. The second step involves a review of your credit and collection policies and procedures.
Increase the percent of orders that are fulfilled without errors. Perfect orders — right product, right quantity, undamaged, delivered on time, to the right location in requested mode (packaging, labeling, time of day), documented with an accurate invoice — will reduce the volume of receivables that are being paid past due as well as improve your AR Dilution rate. For more insight on this topic and the application of the Perfect Order Index (POI) to improve invoice accuracy, click here.
Review your Credit and Collection Policies. If the amount of your past due invoices has been growing, especially those over 60 days past due, you will want to make some adjustments. If you have been diligently following a collection regimen that is pro-active rather than reactive, you should consider tightening your credit approval parameters. If your collection efforts have been a bit haphazard, you will want to tighten them up. The objecctive is to put credit and collection policies in place that will ensure the highest percent possible of current receivables (those not yet due) and forcefully limit the amount of AR that goes beyond 60 days past due.
Parting Thoughts . . .
AR Collateralization can be an excellent way to increase your cash flow, maintain it at an elevated level, and increase it as revenue rises. A bank line of credit or an invoice financing program can also smooth out the bumps and valleys inherent to your cash flow.
Optimizing the benefit and cost of loans collateralized by AR, however, is directly dependent on the quality of your AR asset. This is why credit insurance is sometimes used in conjunction with an ABL facility, Lenders are looking for a clean AR ledger in the sense that there are minimal receivables in the past due aging buckets (especially over 60) and that any “Clutter” has been kept to a minimum.
Both these AR characteristics are evidence of a well-managed organization. In addition, a well-managed AR is both more valuable in terms of its collateral yield (percentage) as well as it total book value. As discussed, a small percentage of seriously past due receivables can cause a large percentage drop in the collateral value of your entire AR portfolio. Since AR is typically one of the top assets on the balance sheets of most companies, you don’t want to discount its value by not being fully committed to taking care of it.