Banking
– Accounts Receivable Collateral
Operating Lines of Credit and Letters of Credit
We highly recommend that, if you have not already
done so, you read the first article in this series, Banking
– Business Loan Application, at :
http://www.youngagainforever.com/banking_business_loan_application.html
Everything explained in this article on accounts receivable
financing will then fall into place naturally.
As in the other articles in this series on fundamental principles
of business banking, we wish to clarify the following facts:
This is not intended to be a detailed accounting or banking
course. I have put together the essential information you need
in order to give yourself the best chance of succeeding in your
business. I shall tell you what your bank manager would like
to hear from you at your meetings. I shall tell you the early
warning signs that your business needs positive action.
These comments are not for retail business finance, or personal
loans; they apply to wholesalers, importers and manufacturers.
To cover the vast amount of banking information, even in thumbnail
format, I shall break it down into various segments. Some will
apply to your business, others may not. I am intentionally phrasing
the segments in very simple layman’s terms. I would advise you
to discuss my advice with your accountant, or even your banker,
before you decide to act on it.
Let us assume that you make an application to a bank, or other
financial institution, for an operating line of credit for your
business.
As explained elsewhere in this series on business bank loans,
the potential lender will examine various important aspects
of the business in order to assess, among other things, the
following:
• The viability of the business
• The profitability of the business
• The track record of the business
• The credit history of the business
• The credit history of the owners
• The quality of the collateral
• The adequacy of the collateral
The collateral to cover the operating line of credit usually
comprises the following:
• Accounts receivable
• Inventory
• Personal guarantees of the owners
• A floating charge covering any other unencumbered assets
Usually, the most important collateral, as far as the bank is
concerned, is the accounts receivable. This article will deal
with accounts receivable as collateral for bank financing and
will treat the subject from the banker’s point of view, so that
you understand what to expect from your lender.
The bank is concerned with the following aspects of the accounts
receivable:
• The average size of the individual account. If it is too small,
it would not be cost effective for the bank to try and collect
delinquent accounts, or to transfer them to a collection agency.
• The mix: If a small number of accounts comprise a large percentage
of the total accounts receivable, the danger to the bank is
obvious. If any of the large receivables becomes delinquent,
a major part of the bank’s coverage is suddenly diminished.
• The credit granting policy of your business. Do you check
customers’ credit rating before granting credit to them?
• The quality of the receivables. Are they small unknown businesses
or better known? What is their credit rating?
• The accounts receivable turnover rate. Is it within the industry
norm? The faster the turnover, obviously the more profitable
the business.
• The terms of sale. Do they conform to the industry norms?
Any special terms to clear slow-moving inventory?
• Receivables created by consignment sales are not receivables
at all, because title does not pass until an invoice is made.
And, in consignment sales, the invoice is not made until the
customer has, in turn, sold the inventory. The bank will not
finance such accounts as being receivables.
• Aging of the receivables: What proportion of the accounts
receivable are seriously past due? Usually, depending on the
terms of sale, the bank will deduct accounts receivable that
are 90 – 120 days old.
• The overall adequacy of the accounts receivable department.
Are there strict follow-up procedures in place regarding credit
and collection procedures? The bank will usually insist on an
aged accounts receivable listing each month to ensure the loan
is adequately covered by collateral.
• FACTORING: This needs a little more explanation, which I've
attempted here: Very briefly, factoring is a service whereby,
for a fee, a factoring company will guarantee that the accounts
receivable that they approve will pay what they owe. Typically,
a factoring company will offer to become your accounts receivable
department. They will process your invoices into aged listings,
approve credit lines or specific credits for each receivable,
and collect the amount due on your behalf. Their fees depend
on whether your business is retail (higher fee) or wholesale,
among other criteria.
Essentially, if the account goes bankrupt, the factoring company
will pay your business the amount owed. Similarly, if the account
is way past due, you can apply to the factoring company to pay
the debt. Obviously, this is a huge plus for the bank which
is extending your business a line of credit, with the accounts
receivable as an integral part of the collateral. The bank will
be more inclined to advance a higher percentage of the receivables
value if they are guaranteed by a factoring company.
The mechanics of how the bank formulates the operating line
of credit for your business depends on various criteria, as
explained. Accounts receivable are prime collateral for the
bank and, depending on their assessment of the accounts receivable,
they may be prepared to advance upto 80% of current receivables.
Some finance companies may advance upto 90%, especially if they
are factoring and financing institutions who are guaranteeing
your business’s receivables.
The above criteria should give you a broad idea as to the importance
of accounts receivable collateral to the bank, and how it will
analyse them.
After all, a simplistic explanation of the whole
idea of obtaining working capital financing, to augment your
own contributed capital, is to be able to purchase products,
sell them to customers (accounts receivable) at a profit, collect
what is due from them (your profit included), and pay your overheads
out of the proceeds. The bank line of credit is essentially
bridging the financing of your business expenses until the money
is collected.
