Buying Accounts Receivable

Companies will sometimes sell their accounts receivable if they need to make cash quickly, improve cash flow or pay off debts. Sometimes selling these accounts – which are assets of the company because they represent money that is owed to the company for a product or service sold – makes financial sense.

It’s a way of getting paid money that’s owed to you now, as opposed to waiting for the days an outstanding account decides to pay you. So how exactly does it work?

When a company provides goods or services to a customer on credit, the general expectation is that the bill will be paid in a predetermined period of time. The minute an invoice is generated, the account becomes an account receivable. For accounting purposes, the amount the company is owed is recorded on the general ledger account as Accounts Receivable.

The amount is recorded on the balance sheet as a current asset, since it represents money the company expects to collect.

Selling off accounts receivables is often referred to as “factoring,” or accounts receivable financing. There are companies that specialize in buying accounts receivable at a discount from the actual face value of the accounts.

The selling company benefits by raising working cash by selling accounts payable to them rather than adding debts by taking out a loan or other traditional lending method.

The company to which the accounts are sold, and from whom they receive accounts receivable financing, quite simply is referred to as the “factor.”

From a simple financial perspective, one might question the wisdom of selling off an asset that has the potential to generate income for a company; however, as referenced earlier, a company may make the decision to choose accounts receivable financing if it needs to generate cash flow quickly.

Sometimes a company that has many accounts receivable with different credit terms to manage will sell off accounts as a financial instrument to provide better cash flow if it’s calculated that the proceeds from the sale can be better used to help grow the company, as opposed to holding on to the accounts and being the “customer’s bank.”

In its simplest form, factoring is an agreement with a company that agrees to buy accounts receivable – in part or all – with the understanding that, as owner, the buyer will now do the collecting of the accounts from the person or company whose debt is outstanding.

Factoring is not a new concept. In fact, it's been around for many years and is by some estimates a $3-trillion business. Companies that specialize in buying accounts receivable know their value and have a track record of being able to collect on them.

In most cases, the factoring company will buy accounts receivable at a discount – typically anywhere from 70% to 90% of the face value – because there is no guarantee that the factor will be able to collect and because of the time and resources needed to credit check the accounts and begin the collections process.

In certain industries, such as the financial industry, multiple accounts receivable from several different companies can be pooled together to form financial instruments referred to as securities, and then sold to investors for a discounted price.

This sort of practice is common in the financial industry, where various types of contractual debts such as residential or commercial mortgages, outstanding auto loans or credit-card debts can be pooled together. Investors get paid through collection of the underlying debt, and the rest is redistributed throughout the new company structure.

By pooling together the securitized assets, the credit risk to investors can be mitigated because you’re dealing with companies with large accounts receivable, making it a somewhat attractive investment.

Securities are not without risk, however, and are subject to fluctuations in the market.

A prime example is the subprime mortgage crisis in 2008, when a large decline in home prices led to the collapse of a housing bubble at the time, leading to the devaluation of housing-related securities. Subprime lending and increased housing speculation were largely blamed, and this led to many securities backed with mortgages – including subprime mortgages widely held by financial companies with large accounts receivable globally – to lose most of their value, as well as to a recession in the U.S.

In some cases, accounts may be deemed virtually uncollectible due to a lack of documentation proving that the debt exists or because a debtor can’t be found, went into bankruptcy or was participating in fraudulent activity.

Those accounts may be sold off to merchants through an account exchange, in which case buyers will demand advances of up to 99% of the value of the accounts, depending on the demand and the collection risk, which in the case of virtually charged-off accounts can be very high.

Still, auctions can be very attractive for buyers who buy the accounts for cheap from companies with large accounts receivable and potentially generate a high payoff should the debt be collected at a later date.

For the seller, it can be a quick and easy way to rid themselves of old, uncollectible accounts that can be written off, because there is no long-term commitment, fees or restrictions on collateral.

When selling accounts receivable to a factor, generally the process begins with finding a factor company, which will scrutinize the accounts and do credit checks on the debtors to determine if they can be collected.

Next, the factor will make an initial offer amount for the accounts, and in many cases will also charge a collections fee of anywhere from 2% to 6% per account, depending on how difficult they deem the collection attempt to be.

It’s estimated that, after fees and discounts, companies that sell off their accounts receivable will get no more than 40% of the face value of the accounts.

If you are considering going into buying accounts as a factor, it’s very important that you consider the business wisely. You need to remember that, while you are buying off accounts that will no longer be the seller's responsibility financially, the accounts do still represent customers of your sellers, some of whom they may continue to do business with.

Sellers will look for several key characteristics in a factor. For instance, what experience does the company have with doing this and how long have they been in the business? Do they have a favorable reputation as being friendly and courteous, or are they money-hungry and relentless in the way they treat customers?

You don’t want to be the factor that destroys a good relationship with a seller's customers.

Next, figure out how you will contact customers. Most use a combination of letters and phone calls, and you should allow sellers to review any scripts or other correspondence you use before agreeing to buy the accounts. Will you refer overdue accounts to collections agencies? You should notify sellers when you intend to do so, and you should be in communication with them about any interactions with their ongoing customers.