Accounts Receivable Financing Definition
Accounts Receivable financing refers to an arrangement where a corporate gets access to capital by selling their outstanding receivable invoices to the bank, wherein the risk of uncollected receivables may lie with the corporate or with the bank depending on the agreement.
It is also called factoring or Bill discounting and is a method by which the company receives cash by selling unpaid customers invoices or receivables. 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.
Examples of Accounts Receivable Financing
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.
Now, with the same example, consider Benji received a booking amount of 20% per car.
It can be observed that Fees paid to the financing company reduced from $ 25,000 to $ 20,000 because the number of account receivables 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.
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.
Financing from the bank would help us get funds in Benji’s bank account instead of cash.
In the below example, we assume Tefac dishonors the bank. i.e Tefac does not have funds to make payment 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.
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.
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.
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. Letter of credit is signed by the buyer’s bank. (Risk of fraud LC hold in this transaction)
It is to be noted, 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.
Accounts receivable financing is a common practice followed mostly by manufacturers as they are in constant need for working capital because the general payment receivable is between 60 to 90 days where is they have to make payment to their creditor on spot basis (to earn cash discount) or between 30 to 60 days period.
Opting Banks for such financing is cheaper and reliable in comparison to privately held companies or financing institutions. However, if the debtor defaults or dishonors the bill on the due date, in case of Banks, we will have to make the payment (in the case – Mr. Benji had to pay banks) but in case of private companies they bare the loss or it is their headache to recover from the debtor and hence they charge higher fees.
Hence, while opting for receivable financing, evaluating should be done on fees and their own creditworthiness. Consecutive higher fees would reduce profits eventually denting firms over-all profitability.
This has been a guide to Accounts Receivable Financing. Here we discuss how Accounts Receivable Financing works along with practical examples and journal entries. Here are the other articles in accounting that you may like –