Making the most of your receivables

It is generally accepted that employees are a company’s best asset.  But what is your second best asset?  It may be your company’s receivables.

Every time you invoice the government, you create a valuable asset – a receivable that has the full faith and credit of Uncle Sam behind it.  Your government receivables are an ironclad commitment that the government must pay (at least for the moment—but that is another story). 

So, how does your company use this obligation to its advantage to fund operations?  There are two options: (1) get a bank loan using the receivables as collateral, or (2) sell the receivables.  Not surprisingly, there are advantages, and disadvantages, to both.

Get a Bank Loan

This type of loan will be priced fairly reasonably, but in turn will have what are called “restrictive covenants” associated with it.  Simply put, these covenants are promises made by the borrower to the lender that the business will achieve certain milestones related to performance—net income targets, balance sheet requirements, financial ratios, etc. 

If the requirements are not met, the borrower has “tripped a covenant” and the loan can be called by the lender.  If a business owner is confident that these requirements can be met, then the bank loan is a good model because it is usually the most affordable alternative. 

In many cases a bank loan must also be personally guaranteed by the business owner.  If there is a default, the bank has the right to pursue repayment through the personal assets of the business owner.

If there is some uncertainty about being able to live within restrictive covenants, or if there is an unwillingness to pledge personal assets, the business owner may want to consider the second option.

Sell the Receivables

This method of financing generally referred to as “factoring,” goes back to the Middle Ages and often has the undeserved reputation of being the route chosen by less-than-credit-worthy companies. 

Recent innovations in financial markets have resulted in a method of selling receivables that has certain advantages over bank loans.  These programs – called structured finance and securitization programs – are often used by some of the largest contractors to fund their businesses and are gaining in acceptance.   It is estimated that at any given point the amount of receivables financed through securitization programs is $250 billion whereas receivables financed by factoring is only one-third of that total.

A structured finance program simply means that the receivables are sold to a special entity that is established for the sole purpose of buying those receivables.  Because the receivables purchased are of the highest credit quality, the borrowing costs are generally lower than traditional factoring.

There are many advantages to selling a receivable to a third party, using a structured finance program.  Generally, the purchaser requires no restrictive covenants.  The business owner does not need to worry about failing to manage the business to the lender’s expectations and, thus, run the risk of losing a funding facility, or risk losing personal assets through a personal guarantee.  

Also, the sale of a receivable, if properly structured, has positive implications for a company’s balance sheet because it turns the receivable into cash, and not into debt.  Financial ratios improve instantly.  Current ratios can improve by more than 100 percent and liabilities to equity ratios can improve by more than 90 percent.  A cautionary note, however; structure is important.  If the sale looks like a loan, it may not pass muster from an accounting standpoint, causing a company to restate their financials.

Finally, this type of financing is essentially unlimited.  As revenues grow, so does funding capacity. 

The principal disadvantage of selling a receivable is that the cost of the facility is usually a bit higher than a bank loan, although the rates are converging as this process becomes more accepted.  

A general rule of thumb is:

• If your annual revenues are less than $50 million, you should pay no more than 1% of the total value of receivables sold.
• Ø  If your annual revenues are between $50 million and $200 million, you should pay no more than .75 percent of the total value of receivables sold.
• Ø  If your annual revenues are more than $200 million annually, you should pay no more than .5% of the total value of receivables sold.

It is true that almost all companies can benefit from using their government receivables to fund operations.  It is also true that there is no one method that is correct for all companies and situations.  A wise business owner will approach the problem with an open mind, considering all options, from a variety of credit providers, and select the best route for the given moment in their company’s development.

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