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Secured short-term

financing

Tomasz Słoński, PhD

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Pledging of accounts

receivable

• Pledging of accounts receivable, or

putting accounts receivable into a
security loan, is characterized by the
fact that the lender not only has a
claim against the receivables but also
has recourse to the borrower.

• Therefore, the risk of default on the

pledged accounts remains with the
borrower.

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Procedure of pledging

accounts receivables

• It is initiated by a legally binding agreement

between the seller of the goods and the

financing institution

• Agreement sets forth in detail the

procedures to be followed and the legal

obligations of both parties.

• The seller periodically takes a batch of

invoices to the financing institution.

• The lender reviews the invoices and makes

the credit appraisals of the buyers (invoices

of companies that do not meet the credit

standards are not accepted for pledging

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Risk in pledging of accounts

receivable

• The financial institution seeks to protect

itself in every phase of the operation:

1. The selection of sound invoices is one

way the lender safeguard itself.

2. If the buyer of the goods does not pay

the lender still has recourse against the

seller

3. The loan will be generally the less than

100% of the pledged receivables

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Factoring accounts

receivable

• Involves the purchase of accounts

receivable by the lender, generally without

recourse to the borrower

• The buyer of the goods is typically notified

of the transfer and is asked to make

payment directly to the financial institution.

• Since the factoring firm assumes the risk of

default of bad debts, it must make a credit

check (it provides not only the money, but

also a credit department for the borrower)

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Procedures for factoring

accounts receivables

• Again, an agreement between the seller

and the factor specifies legal obligations

and procedural arrangements

• When the seller receives an order from

the buyer a credit approval slip is sent

to factor for a credit check.

• After approval, shipment is made and

the buyer is notified to make payment

directly to the buyer company.

• If the factor does not approve the sale,

the seller generally refuses to fill the

order; if the sale is made anyway, the

factor will not buy the account.

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The factor performs three

functions

1. Credit checking
2. Lending
3. Risk bearing
• However, the seller may use a

combination of these functions
by changing provisions in the
factoring agreement.

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Factoring process

• Factoring is normally a continuous process

instead of the single cycle just described.

• Once the routine has been established,

continuous circular flow of goods and funds
take place between the seller, the buyer, and
the factor.

• If the factoring agreement is in force, funds

from this source are spontaneous in the
sense that the increase in sales will
automatically generate additional credit

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Cost of receivables financing

• Both accounts receivables pledging and

factoring are convenient and advantageous,

but they can be costly.

• The credit-checking and risk-bearing fee is 1

to 3 % of the amount invoices accepted, and

it may be even more if buyers are poor

credit risk

• The cost of money is reflected in the interest

rate (usually 2 to 3% above the prime rate)

charged on the unpaid balance of the funds

advanced by the factor.

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Advantages of receivables

financing

1.

The flexibility of this source of
financing

2.

Receivables may be use as a security
for loans that would not otherwise be
granted

3.

The factoring might provide the
services of a credit department that
might otherwise be available at a
higher cost

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Disadvantages of receivables

financing

1.

When invoices are numerous and

relatively small in zloty amount,

the administrative cost involved

might be excessive

2.

Since receivables represent the

firm’s most liquid non-cash assets,

some trade creditors may refuse

on sell on credit to the firm that

pledges or factors its receivables

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Garden Comfort sales 15 sets of furniture per day. The

sale price is 1450 PLN per set. DSO is 40 days.

Variable costs are 55% of sales. The cost of receivables

collection is 20 thousands PLN. The after tax cost of

capital involved in receivables is 7%.
The bank proposition is to buy 50% of invoices. For 40

days credit the bank counts 1,2% provision. The

collection cost will decrease by 5 thousands PLN. The

effective income tax rate is 20%.
a) Is bank proposition attractive?
b) What is maximum growth rate of sales according to

Cash Conversion Cycle, if current CCC is 65 days and

gross profit margin in one conversion cycle was 20%,

and after the change it will be 18,2%.

Factoring analysis

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Note!

1. In this analysis the usage of capital coming from
reduced receivables is skipped (CCC is 20 days
shorter).

2. The effective rate, instead of nominal rate, should
be used. The effective cost is equal to
([(1+0,012)^9]-1)*(7 830 000/2/9)=11,3% and hence
11,3%*435 000 =49155

ad. b) Current maximum rate of sales growth
=(360/65)*20%=5,5*20%=111%
Maximum rate of sales growth after the change
=(360/45)*18,2%=8*18,2%=145,6%
Those growth rates are adequate rates only if all
benefits are invested in NWC.