Accounts Receivable Lending

Lending against accounts receivable – This is what an underwriter looks at.

Current asset financing such as lending against accounts receivable (A/R) requires knowledge, monitoring, and sound underwriting. Bank lenders that rely on the accounts receivable turnover as the primary source of repayment should preferably have control over the proceeds of the accounts receivable via a bank controlled lock box (customers payments mailed directly to the bank). Lock boxes are usually post office locations, and the fact that the checks are being mailed to the bank does not have to be revealed to the customers / account debtors.

The issue of control and disclosure is one that can be sensitive to the borrower. However, it should be understood that the lender must feel comfortable with the quality of the receivables before advancing money on them.  A bank lender will never originate a loan with the goal of having to liquidate the collateral. Nevertheless, the lender must document that option as a contingent source or repayment. Knowing as much as possible about the receivables also supports the underwriting of the primary source of repayment, which is their orderly conversion to cash.

 Underwriting these types of lines means understanding the receivables

Whenever I start looking at a request to finance the A/R of a prospective borrower, the first thing that I do is to understand what it is that the borrower does (the product or service that they sell), and then I find out the following about its A/R:

a)      Who are the borrower’s customers? I need to know not only who they sell to, but their payment history, and concentration. A lot of small and medium businesses are highly dependent on one or two customers. It is important for the lender to feel comfortable with that exposure.

b)      What are the terms provided? The underwriter needs to know this to tailor the facility. As a rule of thumb, eligible receivables are usually limited to 90 days from invoice date, but if the majority of the customers pay the borrower 120 days after invoice date, then something would need to be worked out.

c)      Contra-accounts. These exist when the borrower has accounts payable and receivable with the same party. The account debtor could offset the full payment of the borrower’s receivable, which is the lenders collateral. It is important to determine if the borrower has this type of relationships with any of the customers.

d)     Affiliates and arm length transactions. These also need to be determined. As a rule affiliate receivables are considered ineligible.

e)      For contractors, it is important to determine the bonded jobs and consider them ineligible. I covered this in my contractor article the other day but it essentially has to do with the fact that the bonding company has first dibs on bonded receivables leaving the bank in a junior position.

f)       Are there any consignment sales shown as receivables in the books of the borrower? You might think that consignment is something that only happens in clothing stores, but I have seen relatively large middle market firms show millions of dollars in receivables that are nothing but consignment inventory in the A/R aging.

g)      What kind of cross-aging is present on the A/R aging. Cros-aging refers to a situation where a particular customer is seriously past due on some invoices, but the borrower keeps selling them new merchandise or providing services. When the past due receivable are a small portion of the customer relationship that can be ignored, but when a significant portion is past due it is common to consider all of the receivables from the customer as ineligible. Some banks use 25% as the limit, while others can go as high as 50%.

Getting the information listed above can be obtained from an A/R aging report and by asking the borrower a few questions. Armed with the answers, a good underwriter can prepare a strong analysis of the “conversion of assets” as a primary source of repayment in the credit analysis memorandum.

For more information about A/R financing, this is a good book that covers asset based lending and cash flow analysis plus a lot of other bank credit issues: Credit Engineering for Bankers, Second Edition: A Practical Guide for Bank Lending

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