Accounts receivable and inventory financing allows borrowers to use the value of their receivables and inventory as collateral to secure financing. The financing is then repaid through the normal course of business.
“It is a financing method that allows a company to use their current assets to fund growth,” explains Rick Arcaro, vice president of middle market lending at Comerica Bank.
Smart Business spoke with Arcaro about accounts receivable and inventory financing, how companies can benefit from this type of financing and what factors banks consider when evaluating potential banking relationships.
What are the basic principles of accounts receivable and inventory financing?
Basically, it is a financing method where banks loan money against a company’s accounts receivable and inventory. The advance rates are determined by the risk associated with each asset. Typically, advance rates are higher with accounts receivables than inventory because it’s easier to convert a receivable to cash versus liquidating inventory. Eligible accounts and inventory will vary depending on the bank, but typically accounts receivables more than 90 days from an invoice date or concentrated receivables may be discounted or considered ineligible. Concentrated receivables mean that a single customer has a large percentage, or high concentration, of the overall receivables for the company.
How can a company benefit from this type of arrangement?
A company can take advantage of trade discounts by paying suppliers sooner and receiving a discount. For instance, some vendors grant a 3 percent discount if they are paid within 10 days. If you have an account receivable and inventory line you can take advantage of these savings. In other words, you can pay your vendors before cash is collected from a transaction. The primary benefit of this type of financing is being able to grow your business by using your assets without having to put additional capital into your company or waiting for collections to arrive.
Companies that have strong cash flow are less likely to need this type of financing because they have enough cash to fund operations. Predominately, accounts receivable and inventory financing is for companies that are outgrowing their current cash flow. It is also helpful for companies that hold high levels of inventory.
How does a bank assess a borrower’s financial position?
We require financial statements from a CPA, receivable agings, accounts payable agings and inventory reports. Some banks will be more comfortable with a company that has strong cash flow. Some financial institutions are more comfortable with strong collateral. For instance, a finance company will lend to a company losing money as long as it has good collateral that can be strictly monitored. On the other hand, a bank will likely want a profitable company that also has good collateral. Each bank may look at each company differently. Generally debt to equity and the turnover of the assets, or how fast the asset becomes cash are key factors.
What other factors are considered?
Other factors we consider are similar to those of any new banking relationship: Are we comfortable with the company’s management? Are we confident it can execute its plan? Does it have a good business model? How does the company stack up within its own industry?
What types of receivables are ineligible?
Generally, receivables that are 90 days past the invoice date are normally ineligible. Also, a portion of a concentrated receivable may be deemed ineligible. For example, if you are selling to a large retailer and they account for 40 percent of your total receivables, many banks will not give credit for any amount over 30 percent 10 percent would be ineligible.
While these factors may cause an accounts receivable to be ineligible, there are strategies that can create eligibility for these types of accounts. It is possible to buy credit insurance that guarantees the receivable will be paid. Foreign accounts receivables are also typically ineligible. However, by having foreign credit insurance in place for these receivables, they could also be considered an eligible receivable. Credit insurance is key with questionable accounts receivables. Overall A/R and inventory financing can be a significant tool to help grow your company.
RICK ARCARO is vice president of middle market lending at Comerica Bank. Reach him at (213) 486-6239 or firstname.lastname@example.org.