In the Balance Sheet, accounts receivables and inventory normally form a high proportion of our current assets. So how familiar are we with the utilization of our company’s current assets like accounts receivable and or inventory as collateral for short term secured borrowing?

Incidentally, for any acceptable collateral, there must be price stability over time , not easily obsolete and have a ready market, breadth and depth.

Part 1 of this article deals with the following two ways of using the Accounts Receivable as collaterals for secured borrowing.

• By pledging Accounts Receivable and
• By factoring of Accounts Receivable

Basically, pledging is the assignment of accounts receivable to the lender. There is no outright sale of accounts receivable to the financer.

The accounts receivable is merely acts as collateral for the loan/borrowing.

The pledging process will involve the following:

• Selecting “quality” account receivables. The lender will consider the average payment period of the debtor and questionable low quality receivables are rejected;
• Adjustment of accounts for cash discount and good return;
• Determination of advance from a range of 50% to 75% of the selected accounts receivable value and
• A legalized written agreement is drawn.

Unlike pledging, when we factored our accounts receivable/ debts it is actually an outright sale of our company’s account receivable to the factor which can be a finance company or any financial institution.

The factoring process is as follows:

• The factor will again peruse through your stream of accounts receivable. In the event that your factoring facility is on a continuous process then the factor will do the credit evaluation of your potential buyers/customers;

• Notification: your customers are notified and requested to make payment directly to the factor. This notification can be vide a letter of notification and a chop on the company invoices/statement of account to your customers;

• Non recourse clause meaning that the factor will bear the credit risk;

• Before any Cash advance are paid by the factor to the seller certain % of the receivables value are deducted for reserved for sales return or cash discount, commission (non-recourse clause) and interest are charged on advances.

Usually, factoring is a relatively more expensive source of short term financing as a result of increase in administrative costs, credit evaluation, lending and risk bearing

So, before you consider factoring do look at some of the following advantages and disadvantages:

Pros:

• A quick way of converting credit sales into cash sales;
• Cash flows are more predictable;
• With a non recourse clause , the seller can reduce its credit administration and collection costs;
• It improves the cash conversion cycle hence improving supplier relationship;
• It’s a short term solution to overtrading-overstretching your sales with proper capital back up;
• It leaves management to concentrate on its core competencies rather than worrying on its working capital requirement/ credit collection;

Cons:

• It might be costly when accounts receivables are numerous and relatively small in value;
• It’s might reflect as a stigma that the company is facing some sort of financial/liquidity challenge;
• Might not be a right way to raise liquidity as we are using highly liquid assets as collaterals.

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Related Entries

• Short Term Financing:Inventory Financing (Part 2)
• Financial Ratio on Assessing The Liquidity Of A Company
• Credit Management: Costs in Extending Credit & ROI on Receivables
• Hypothecation
• Cash Operating Cycle And Ways To Improve Cash Flows