Accounts Receivable Financing

Accounts receivable financing has several advantages, including avoiding the need for long-term financing and obtaining a recurring cash flow base. Accounts receivable financing has the drawback of high administrative costs when there are many small accounts. However, with the use of computers these costs can be curtailed. Accounts receivable may be financed under either a “factoring“ or “assignment arrangement“. Factoring refers to the outright sale of accounts receivable to a bank or finance company without recourse. The purchaser takes all credit and collection risks. The proceeds received by the selling company are equal to the face value of the receivables less the commission charge, which is typically 2 to 4 percent higher than the prime interest rate. The cost of the factoring arrangement is the factor’s commission for credit investigation, interest on the unpaid balance of advanced funds, and a discount from the face value of the receivables where high credit risks exist. Remissions by customers are made directly to the factor.
The advantages of factoring include:

• Immediate availability of cash
• Reduction in overhead since the credit examination function is no longer required
• Utilization of financial advice
• Receipt of advances as needed on a seasonal basis
• Strengthening of the balance sheet position

The drawbacks to factoring include both the high cost and the poor impression left with customers because of the change in ownership of the receivables. Also, factors may antagonize customers by their demanding methods of collecting delinquent accounts. In an assignment, there is no transfer of the ownership of the accounts receivable.
Receivables are given to a finance company with recourse. The finance company typically advances between 50 and 85 percent of the face value of the receivables in cash. The borrower is responsible for a service charge, interest on the advance, and any resulting bad debt losses. Customer remissions continue to be made directly to the company.
The assignment of accounts receivable has a number of advantages, including the immediate availability of cash, cash advances available on a seasonal basis, and avoidance of negative customer feelings. The disadvantages include the high cost, the continuance of the clerical function associated with accounts receivable, and the bearing of all credit risks.
The financial manager should be aware of the impact of a change in accounts receivable policy on the cost of financing receivables.