Selling the accounts receivable of a business is accomplished by shifting them to a third party in exchange for cash and a hefty interest charge. By doing so, cash is received immediately, rather than waiting for customers to pay under normal credit terms. Under what circumstances should this option be used, and what are the advantages and disadvantages of doing so?
Mechanics of Selling Accounts Receivable
When a business sells its accounts receivable to a third party (known as a factor), the terms offered by the factor essentially drive the circumstances under which the arrangement can be used. In essence, a business sells its accounts receivable to a factor in exchange for about 70% to 85% of the face value of each invoice, plus a fee that ranges from 2% to 5% of the face amount of the invoice. Once the factor collects payment on the invoice, it remits back to the selling company the difference between the face value of the invoice and the amount of cash already provided to the company (less the fee already noted).
This arrangement is, in essence, a loan with a very high interest rate. For example, assume a 3% fee on a $1,000 invoice, with only 80%, or $800, of cash actually paid to the company. The fee is therefore $30 to use $800 for the typical 30-day term of an invoice, which is an annualized borrowing rate of 45% (calculated as $30 x 12 months, divided by $800).
When to Sell Accounts Receivable
Given this extraordinarily high interest rate, it should be a given that selling accounts receivable is a valid option only under very particular circumstances. First, it is usually used only when all other more reasonable forms of funding (such as bank loans, the sale of stock, or reducing working capital) have been eliminated. In addition, there must be an opportunity for a high rate of turnover in sales. For example, a business is in a rapidly-expanding market, where there is considerable demand for its goods and services. In this case, if it can convert a sale to cash at once and earn a reasonable profit on each transaction, it can pay the factor's fees and still generate more cash than would have been the case if it had not made the sale. If the business can make such sales in high volume, many times per year, it can earn a long-term profit by selling its accounts receivable.
However, selling accounts receivable can be a deadly form of financing when a business earns only a small profit and is not rapidly growing its sales (in short, the most common state of affairs for most businesses). In this case, the factor will suck all profits out of the business, leaving the entity in worse shape than had been the case before it elected to use this form of financing.
Thus, selling accounts receivable works best in high-growth environments, and is to be avoided under most other circumstances. A reputable factoring firm will recognize which situations dovetail best with the financing it offers, and so may advise a business to look elsewhere for funding if its business situation is not amenable to the sale of receivables.