Accounts Receivable: An Unlikely Source of Cash

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Your accounts receivable are obviously worth money: just as soon as a client or customer gets around to paying his invoice, you'll have money in your hands. But in the meanwhile, those invoices are just worth the paper they're printed on. You can't spend the money that they promise you until you actually receive payment. That doesn't mean that accounts receivable can't be a source of cash in the short-term, however.

Using Accounts Receivable for Cash

Because banks and other lenders consider your company's accounts receivable to be an asset, you can use them to take out an asset-based loan with your accounts receivable as collateral. Alex Kwechansky's background in public accounting and business reorganizations has put him on both sides of the table during this sort of loan. He describes a loan based on accounts receivable:

This loan uses the company's customers themselves as the debtors. Thus, the borrower is secondarily responsible to pay the lender. This works either by having the receivables formally secured with actual notice sent to the customers or (with better, established borrowers) being trusted to immediately repay the lender as funds are collected. As funds are collected, the access to new funds becomes conditionally available. Audits are occasionally performed to check for compliance.

With this sort of loan, you generally can borrow between 75 and 80 percent of the value of your invoices, although with the various fees and paperwork that go along with the loan, it's easy to wind up without much of the original amount of an invoice left over.

Another alternative is to work with a factor to sell your accounts receivable outright. Kwechansky says:

Less financially stable companies can use other lenders, generally called factors, to actually buy the account receivable and to collect the funds directly. They pay a reduced amount for the receivable but the borrower gets upfront cash and no collection delays or collection costs. They can also choose to sell one invoice at a time as they need cash than to be tied to an all in A/R commitment. Both of these accounts receivable loans have their downsides but, from my experience, they are less complicated and less encumbering than going to a bank.

Taking Out a Loan

In order to apply for and receive an asset-based loan, you can expect to hand plenty of paperwork over to a lender. Much of the list is the same if you are considering factoring your accounts receivable. That paperwork will include financial statements and tax returns for the business, so that a lender can establish the stability of the business. Depending on your business structure, you may also be asked to provide personal financial records for the owner as well.

You'll also need to hand over the paperwork on your accounts receivable, including a customer list and agings reports for either a loan or factoring. For a loan, you'll be asked for information about your inventory (not just what you already have on hand but your raw materials and how long you expect it to take to move your inventory) and your accounts payable details. Such information is necessary to establish your ability to pay back a loan.

It's important to remember that just because you apply for a loan of a certain amount, it's up to the lender to decide how much credit to extend. While some lenders will offer a loan of up to 80 percent of your accounts receivable, they may reduce the amount they make available based on the stability of your company. Some banks may also take your inventory into account when calculating a loan.

Once you've received an asset-based loan, you should expect that your lender will establish some sort of reporting requirement to insure that you are collecting your accounts receivable in a timely manner, as well as keeping your financial situation otherwise in order. Just like with a credit card, lenders can reduce the amount available to you to borrow based on a change in your business finances — that sort of situation requires you to immediately make payments to get the balance of your loan down to an acceptable level.

The Drawbacks to Loans

Marc Bowers is the co-founder of the Grun Company, which manufactures erosion control equipment. The company depends on factoring its accounts receivables for survival, but the situation isn't entirely perfect:

Factoring is expensive. It is the equivalent of working for free; you pass a lot of margin through to the factoring agent. It has made a difference in our ability to function because it is one of our very few, and very austere, sources of production funding. If we weren't factoring right now, then we wouldn't be producing anything to sell and we would be dead in the water. Period.

There can be issues along the way when you use your accounts receivable as collateral, as well. Everything from simple paperwork issues to problems with a lender can pop up, depending on who you work with. Kwechansky routinely conducts business fraud investigations. He notes that the audits that some lenders perform can actually cause problems with a loan, even when the borrower's books are in order:

These audits are generally performed long after the fact and can create more problems than they solve. Lenders have a habit of hiring the cheapest auditor. Often you get what you pay for.

Using your accounts receivable in order to get cash is not the best fit for every business. It is more commonly seen in businesses based on manufacturing, because the need for capital to continue production is a situation that requires capital even if invoices aren't immediately paid. But just because that is the most common situation doesn't mean that your business should or shouldn't consider the option. Instead, it means that you'll need to run the numbers for yourself and see what the benefits or drawbacks are in your individual situation.