Accounts Receivable Financing

Accounts Receivable Financing Definition

Accounts Receivable financing refers to an arrangement in which a company obtains finance by selling its outstanding receivable invoices to a bank. The risk of uncollected receivables may lie with the company or with the bank depending on the agreement. It is also known as factoring or bill discounting.

Accounts receivable financing is a common practice that is mostly used by manufacturers because they are constantly in need of working capital because their general payment receivable is between 60 and 90 days, whereas they must pay their creditor on a spot basis (to earn cash discount) or within 30 to 60 days.

Understanding Accounts Receivable Financing

Normally banks undertake such financing or bill discounting activities for interest or professional fees. However, there are special-purpose funds & private investors who specialize in such transactions.

Banks are more cost effective and reliable than private investors or financial institutions when it comes to such accounts receivable financing.

Banks typically impose smaller costs; but, if the debtor fails to pay or dishonours the bill on the due date, the company is responsible for payment. Private investors charge greater fees since they share the risk of loss if the debtor defaults.

How Accounts Receivable Financing Work?

Let us understand the concept of accounts receivables financing with the help of examples.

Example #1

Benji is a car dealer and has sold the 5 cars worth $35,000 each to M/s Tefac INC. Tefac agrees to make the payment in 3 months’ time. However, due to the urgent need for cash, Benji took up accounts receivable financing facility.

Account Receivable Financing Example 1-1
Account Receivable Financing Example 1-2
Example #2

Now, with the same example, consider Benji received a booking amount of 20% per car.

Account Receivable Financing Example 2-1
Account Receivable Financing Example 2-2

It can be observed that Fees paid to the financing company reduced from $ 25,000 to $ 20,000 because the number of account receivablesAccount ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read more also decreased. The fees are variable, and mostly in line with the risk they take depending on the outstanding amount, the creditworthiness of the Buyer, and the creditworthiness of the principal debtor, i.e., Tefac INC.

Example #3

Now sample example, but Benji opts to get financing from Bank because this would help me save on fees, but there is risk involved. Risk is if Tefac doesn’t pay Bank, i.e., dishonors the bill on the due date, Benji would have to pay the bank.

Account Receivable Financing Example 3
Account Receivable Financing Example 3-1

Financing from the bank would help us get funds in Benji’s bank account instead of cash.

Example #4

In the below example, we assume Tefac dishonors the bank. i.e., Tefac does not have funds to make payments to the bank.

If a bill is dishonored, we would have to make the payment to the bank in 3 days’ time. Fees paid to the bank is our loss as we would not get it to refund.

Account Receivable Financing Example 4
Account Receivable Financing Example 4-1
Example 5

TransX Exports GmBH has received an order to ship 10 containers ($3,000,000) per month for a period of 12 months. The importer has agreed to pay once the container reaches its port. FYI – The shipment takes 21 days to reach importers port.

Example 5
Example 5-1

It is to be noted, the higher the account receivable value for financing, the lower is the Bank fee. The reason being, the transaction itself. Higher the transaction, the lower is the risk of default.

Example #6

In the above example, instead of financing accounts receivable, Transx Export GmBH has an option to ask for a Letter of Credit. By asking this, he can provide 30 to 60 days credit to his buyer. By getting a letter of credit, TransX can book revenue straight away, and it further reduces the cost. However, please be informed such transactions are valid only for the Export-Import trade. A Letter of creditLetter Of CreditA letter of credit is a payment mechanism in which the issuer's bank gives an economic guarantee to the exporter for the agreed payment amount if the buyer defaults. In international trade, buyers employ LC to reduce credit risk.read more is signed by the buyer’s bank. (Risk of fraud LCLCThe full form of LC is a Letter of credit. A letter of credit is a document issued by the buyer's bank, known as the issuing bank, that guarantees that the buyer will pay the correct amount to the seller on time, and that if the buyer fails to pay the amount to the seller, the bank is liable to pay the outstanding dues to the seller on behalf of the buyer.read more hold in this transaction)

Example 6
Example 6-1

It is to be noted that bank fees purely depend on your past credit score. Despite high-value transactions, if the credit score is below bank accepting limits, you would get higher fees.

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