This is the first installment of The Credit Junction's 3-part guide to assets. In this piece, learn the ins and outs of accounts receivable as collateral.
To some, A/R is worthless collateral. To others, it’s the best, most liquid collateral there is (other than cash, of course). Is the polarization of opinions warranted? Quite frankly, YES. For, if you have no control over your collateral, you basically have no collateral. The naysayers all have one thing in common: they allow the borrower to collect the receivables and then use the proceeds to make payments against the loan. Or not. You see, when all is well with the borrower, the loan will perform perfectly. Then again, nobody needs collateral when a borrower is generating positive cash flow. Collateral is for when the borrower is not generating enough cash to meet its obligations. It’s during these times that the borrower must decide who to pay and who not to pay. And, when the choice is between payroll, critical suppliers and the lender, the lender tends to lose out.
Now, for those lenders that require the cash proceeds of the A/R to be paid by the borrower’s customers directly to the lender, the “collateral” naturally performs much, much better. The borrower no longer gets to choose who to pay and the lender is always first. But even this superior arrangement must be exercised with sound, experienced receivable financing judgment. While control is definitely key, collection still relies on one common sense attribute: the borrower’s customer must actually have the legal obligation to pay in the first place. Some might think that this last part would be self-evident, but alas, they’d be wrong.
There are a myriad of situations which can cast a pall over a lender’s ability to collect. These can be summarized into three main groups:
The borrower’s customer simply doesn’t owe any money, period
In order to increase the amount that they can borrow against receivables, borrowers will often offer customers the opportunity to purchase goods “on consignment”, meaning that the customer never owes the borrower money unless and until the goods are either used or resold by the customer. Then, any/all remaining goods can be returned with no obligation to pay.
Yes, the customer owes the borrower money, but the borrower also owes the customer money
In the easier to detect case, the borrower both sells to and buys from the customer, creating a right-of-offset by the customer or “contra-account”. This can be found by comparing the borrower’s A/R to their A/P and looking for the same name on both. In the harder to quantify case, the borrower invoices the customer but has yet to fully deliver on the underlying “sale” or contractual obligation. These cases are especially tricky because the remaining obligation of the borrower to their customer, if unfulfilled, can sometimes cause economic harm to the customer. This damage is often far in excess of not only the particular invoice in question, but also the entire balance owed from the customer to the borrower
Yes, the customer owes money, but some other entity has rights to that money ahead of the borrower
One example of this is where the borrower uses other people/firms to perform the service for the customer. In certain situations, if these people/firms are not paid by the borrower, these people/firms can collect the receivables due from the borrower’s customer in order to get paid (mechanic’s liens). Another example is where the borrower resells certain commodities without ever paying for them. The source of the commodities can intercept payment from the borrower’s customer under certain Federal and State Statutes.
All this to say, if you don’t know what you’re doing, then A/R can turn out to be worthless collateral. However, if you do know what you’re doing, then A/R is a great form of collateral.
Stay tuned for the next installment of this series coming soon to the TCJ blog!
Tom Siska serves as the SVP, Head of Underwriting at The Credit Junction. He brings over 30 years of small business and middle-market commercial lending leadership experience to our team. Previously, he worked at North Mill Capital, where he was responsible for redesigning their risk rating model to bridge across both factoring and asset based lending financing products. He has held key leadership positions at Greystone Commercial Services, Credit Support International, GE Capital, Bay View Funding and Riviera Finance.
He holds a B.S. in Finance and Marketing from DePaul University and an MBA in Finance and Accounting from the University of Chicago.