Sometime around 1750 B.C.—the period of the First Babylonian dynasty—King Hammurabi made financial history twice. First, he enacted the Code of Hammurabi: 282 laws recorded on stone tablets that established the wages of an ox driver, among other things. And second, he developed the concept of accounts receivable (AR) as collateral. Ox drivers may be a thing of the past but AR financing remains with us, making it one of the oldest forms of lending in the world.
Despite marketplace demand and centuries of success, AR financing lacks for a proper strategy at many banks. The time to change that state of affairs couldn’t be better, though. As the economy expands, more financial institutions have diversified their portfolios to include commercial lending. They’re also starting to offer AR financing based on customer demand.
The Commercial Finance Association recently estimated that asset-based lending and factoring markets held a combined $246 billion in U.S. commitments during 2017, representing growth of 7.9 percent over the previous year. Yet banks can’t dive into this area without proper consideration, planning and strategic focus. Bankers must understand their clients’ key business drivers; determine the best model for both their institution and clients; and leverage the right technology to succeed.
Three key business drivers
Before deciding if, how and when to approach AR financing, banks should recognize the three primary factors that commonly prompt businesses to seek this type of loan:
- receivables they carry as a percentage of total assets
- rate of growth
- how fast customers pay debts.
The average accounts receivable turn rate for U.S. businesses in recent years has hovered between 50 and 52 days. Business owners must monitor not only the turn rate itself but also the unpredictability of payments across their customer base. Routinely, large customers take time to pay—and in some cases, have their own cash flow constraints. Or, large institutional account debtors stretch their small business suppliers, using them as cash management vehicles.
Businesses can address these issues and gain many benefits from successfully financing receivables. The instant availability of cash on hand can mean the difference between growth and stagnation; it can even translate to a discounted cost of goods sold with vendor negotiations.
Weighing the best models
Bankers have many types of AR financing to consider, including asset-based lines of credit, recourse factoring and non-recourse factoring. They must weigh the benefits to the potential borrower against strategic credit controls to decide which vehicle will work best. Decisions are often driven by the size of the proposed relationship, availability of data around each account financed and overall financial health of the business and its owners.
The underwriting method is also significant. Most factoring relationships tend to emphasize account debtors and their ability to pay a valid receivable. In asset-based lending and traditional borrowing-base solutions, the underwriting emphasis falls on the financial strength of the business and its ability to produce quality goods and services. Each structure has pros and cons for the lending entity and borrower.
The control the financial institution exercises over the accounts also helps determine the best fit. Here, specific elements of the loan structure become important. For example, will account debtors be notified of the lien position? Will payments be directed to the lender? Other key factors include the institution’s history of providing this form of financing. Does the bank have properly trained commercial lenders experienced in financing accounts receivable? Do they have a portfolio management system that helps track collateral value to determine advance rate structures?
The final decision should be made after joint consultations that include the lender, business owners and key members of the business’ advisory team, including the CPA. Also consider factors such as:
- pace of growth
- size of credit need
- financial strength of the business and account debtors
- number of monthly transactions
- financing method cost versus expected benefit.
Bankers can act as advisors during this process, providing clear lines of questioning and detailed information on the way to a mutually beneficial decision and long-lasting relationship.
High time for high-tech
If a bank wants to move forward with AR financing to better serve business clients, it must leverage technology to enable success. Dated, siloed systems that rely on a manual, paper-based approach are simply too inefficient and slow to properly handle modern requirements. Up-to-date, automated platforms allow for greater efficiency and transparency.
In recent years, technology advances have impacted how banks track collateral values, covenants and exceptions in loan agreements. These updates allow them to quickly retrieve necessary financial data, which significantly reduces the time it takes a credit officer to monitor revolving credit facilities. Before entering the market, banks should explore their options, vet technology vendors and seek solutions that best match their corporate culture and risk appetite.
Currently, the U.S. has 30.2 million small businesses. The majority—more than 24 million—are non-employer businesses, while another 2 to 4 million have fewer than 10 people. In the years to come, many will need some form of working capital financing to expand. Community and regional financial institutions must plan for how to best address this need.
When banks grasp the business drivers, pick the best strategy and leverage modern technology, they will stand poised to take advantage of this market opportunity. With solid AR financing in place, the benefits for borrow and lender alike will be carved in stone: much like Hammurabi’s code itself.
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Patrick True is senior risk analyst at ProfitStars.