A larger organization can convert its accounts receivable into cash at once by securitizing the receivables. This means that individual receivables are aggregated into a new security, which is then sold as an investment instrument. A securitization can result in an extremely low interest rate for the issuing entity, since the securities are backed by a liquid form of collateral (i.e., receivables).
In essence, a receivables securitization is accomplished with these steps:
- Create a special purpose entity (SPE)
- Transfer selected accounts receivable into the SPE
- Have the SPE sell the receivables to a bank conduit
- Have the bank conduit pool the company's receivables with those from other companies, and issue commercial paper backed by the receivables to investors
- Pay investors back based on cash receipts from the accounts receivable
These process steps indicate that the securitization of accounts receivable is complex, and so is reserved for only larger companies that can attend to the many steps. Also, the receivables included in a pool should be widely differentiated (so there are many customers), with a low historical record of customer defaults.
Despite the complexity, securitization is tempting for the following reasons:
- Interest cost. The cost to the issuer is low, because the use of the SPE isolates the receivables from any other risks associated with the company, typically resulting in a high credit rating for the SPE. This credit rating must be assigned by a rating agency, which will take into account such factors as the historical performance of the receivables in the pool, unusually large debtor concentrations in the pool, and the conservatism of the issuing company's credit and collection policies.
- Non-recordation. The debt incurred by the company is not recorded on its balance sheet, since the debt is passing through an SPE.
- Liquidity. The flow of cash into the business can be accelerated, rather than waiting for customers to pay their bills.
The low interest cost of a receivables securitization can only be achieved and maintained if there is considerable separation between the SPE and the company. This is accomplished by designating the transfer of receivables to the SPE as a nonrecourse sale, where creditors of the company cannot access the transferred receivables. In short, the company cannot be allowed to regain control over any transferred receivables.