Selling accounts receivable to fund a business
/What are Accounts Receivable?
Accounts receivable are the amounts owed by customers when you sell them goods or services on credit. It is one of the most liquid assets, since customers typically pay for their invoices within quite a short period of time, ranging from a few weeks to a few months. Because receivables are so easily convertible into cash, it is not that difficult to sell them in order to provide almost immediate funding for your business.
How to Sell Accounts Receivable
You might choose to sell your accounts receivable in order to accelerate cash flow. Doing so is accomplished by selling them to a third party in exchange for cash and a hefty interest charge. This results in an immediate cash receipt, rather than waiting for customers to pay under normal credit terms. Under what circumstances should this option be used, and what are the advantages and disadvantages of doing so?
The Mechanics of Selling Accounts Receivable
When a business sells its accounts receivable to a third party (known as a factor), the terms offered by the factor essentially drive the circumstances under which the arrangement can be used. In essence, a business sells its receivables in exchange for about 70% to 85% of the face value of each invoice, plus a fee that ranges from 2% to 5% of the face amount of the invoice. Once the factor collects payment on the invoice, it remits back to the selling company the difference between the face value of the invoice and the amount of cash already provided to the company (less the fee already noted).
This arrangement is, in essence, a loan with a very high interest rate. For example, assume a 3% fee on a $1,000 invoice, with only 80%, or $800, of cash actually paid to the company. The fee is therefore $30 to use $800 for the typical 30-day term of an invoice, which is an annualized borrowing rate of 45% (calculated as $30 x 12 months, divided by $800).
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When to Sell Accounts Receivable
Given the high interest rate associated with the sale of receivables, it should be a given that selling receivables is a valid option only under very particular circumstances. First, it is usually used only when all other more reasonable forms of funding (such as bank loans, the sale of stock, or reducing working capital) have been eliminated. In addition, there must be an opportunity for a high rate of turnover in sales. For example, a business is in a rapidly-expanding market, where there is considerable demand for its goods and services. In this case, if it can convert a sale to cash at once and earn a reasonable profit on each transaction, it can pay the factor's fees and still generate more cash than would have been the case if it had not made the sale. If the business can make such sales in high volume, many times per year, it can earn a long-term profit by selling its accounts receivable.
When Not to Sell Accounts Receivable
There are several circumstances under which it does not make sense to sell your accounts receivable. These situations are as follows:
Low profitability. Selling accounts receivable can be a deadly form of financing when a business earns only a small profit and is not rapidly growing its sales (in short, the most common state of affairs for most businesses). In this case, the factor will suck all profits out of the business, leaving the entity in worse shape than had been the case before it elected to use this form of financing.
Current payment terms are short. Another time in which factoring is not useful is when the terms under which customers are currently paying are relatively short. For example, if it is customary and accepted practice for customers to pay in 10 or 15 days, then there is little advantage to be gained from factoring, especially when considered in relation to its cost.
When other options are available. Do not sell your receivables when lower-cost financing is available. This may be a longer-term bank loan, or perhaps a line of credit. In either case, the bank is likely to offer a lower effective interest rate than the rate that a factor will charge. Consequently, these other sources of financing should be tapped first, before considering factoring as an option.
Thus, selling accounts receivable works best in high-growth environments, and is to be avoided under most other circumstances. A reputable factoring firm will recognize which situations dovetail best with the financing it offers, and so may advise a business to look elsewhere for funding if its business situation is not amenable to the sale of receivables.
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