Accounts Receivable Financing – Don’t Worry, Be Happy
There is a reason why accounts receivable financing is a four-thousand-year-old financing technique: it works. Accounts receivable financing, factoring, and asset-based financing all mean the same thing related to asset-based lending- invoices are sold or pledged to a third party, usually a commercial finance company (sometimes a bank), to accelerate cash flow.
In simple terms, the process follows these steps. A business sells and delivers a product or service to another business. The customer receives an invoice. The business requests funding from the financing entity, and a percentage of the invoice (usually 80% to 90%) is transferred to the business by the financing entity. The customer pays the invoice directly to the financing entity. The agreed-upon fees are deducted, and the remainder is related to the business by the financing entity.
How does the customer know to pay the financing entity instead of the business they are receiving goods or services from? The legal term is called “notification.” The financing entity informs the customer in writing the financing agreement, and the customer must agree to this arrangement. In general, if the customer refuses to agree in writing to pay the lender instead of the business providing the goods or services, the financing entity will decline to advance funds.
Why? The main security for the financing entity to be repaid is the creditworthiness of the customer paying the invoice. Before funds are advanced to the business, there is a second step called “verification.” The finance entity verifies with the customer that the goods have been received or the services were performed satisfactorily. There being no dispute, it is reasonable for the financing entity to assume that the invoice will be paid; therefore, funds are advanced. This is a general view of how the accounts receivable financing process works.
Non-notification accounts receivable financing is a type of confidential factoring where the customers are not notified of the business’ financing arrangement with the financing entity. One typical situation involves a business that sells inexpensive items to thousands of customers; the cost of notification and verification is high compared to the risk of nonpayment by an individual customer. In addition, it simply may not make economic sense for the financing entity to have several employees contacting hundreds of customers for one financing customer’s transactions daily.
Non-notification factoring may require additional collateral requirements such as real estate; superior credit of the borrowing business may also be required with personal guarantees from the owners. As a result, it is more difficult to obtain non-notification factoring than the normal accounts receivable financing with notification and verification provisions.
Some businesses worry that if their customers learn that a commercial financing entity is factoring in their receivables, it may hurt their relationship with their customers; perhaps they may lose their business. What is this worry, why does it exist, and is it justified?
The MSN Encarta Dictionary defines the word worry as:
verb (past and past participle worried, present participle worrying, 3rd person present singular worries)Definition:
1. transitive and intransitive verb be or make anxious: to feel anxious about something unpleasant that may have happened or may happen or make somebody do this
2. transitive verb annoy somebody: to annoy somebody by making insistent demands or complaints
3. transitive verb try to bite animal: to try to wound or kill an animal by biting it
a dog suspected of worrying sheep
4. transitive verb
Same as worry at
5. intransitive verb proceed despite problems: to proceed persistently despite problems or obstacles
6. transitive verb touch something repeatedly: to touch, move, or interfere with something repeatedly
Stop worrying about that button, or it’ll come off.
noun (plural worries)Definition:
1. anxiousness: a troubled unsettled feeling
2. cause of anxiety: something that causes anxiety or concern
3. period of anxiety: a period spent feeling anxious or concerned…”
The opposite is:
“not to worry used to tell somebody that something is not important and need not be a cause of concern (informal)
Not to worry. We’ll do better next time.
No worries, U.K. Australia New Zealand used to say that something is no trouble or is not worth mentioning (informal)”.
Query: if a business is financing its invoices with accounts receivable financing, is this an indication of financial strength or weakness? Query: from the customer’s point of view, if you are buying goods or services from a business that is factoring in their receivables, should you be concerned? Query: is there one answer to these questions that fits all situations?
The answer is it’s a paradox. A paradox is a statement, proposition, or situation that seems absurd or contradictory, but in fact, is or may be true.
Accounts receivable financing is both a sign of weakness about cash flow and strength concerning cash flow. It is a weakness because funds are not available to provide cash flow to pay for materials, salaries, etc. It is an indication of strength because cash can facilitate a business’s need for cash to grow after funding. It is a paradox. When properly structured as a financing tool for growth at a reasonable cost, it is a beneficial solution to cash flow shortages.
If your entire business depended on one supplier, and you were notified that your supplier was factoring in their receivables, you might have a justifiable concern. If your only supplier went out of business, your business could be severely compromised. But this is also true whether or not the supplier is utilizing accounts receivable financing. It’s a paradox. This involves matters of perception, ego, and character of the personalities in charge of the business and the supplier.
Every day, every month, thousands of customers accept millions of dollars of goods and services in contracts that involve notification, verification, and the factoring of receivables. For most customers, “notification” of accounts receivable financing is a non-issue: it is merely a change of the name or addresses of the payee on a check. This is a job for a person in the accounts payable department to make a minor clerical change. It is a mainstream business practice.