Businesses resort to various means to finance operating activities and remain economically afloat. Traditional funding procedures involve the issuance of debt or equity products in public markets or through private conduits. Other forms of business financing include pledging accounts receivable, funding through fixed-asset attachment procedures and factoring customer receivables.
Accounts receivable pledging is a practice in which a company uses money it expects from customers -- that is, customer receivables -- as collateral for a loan. This process enables the business to fund its operating activities at a cost that may be cheaper than a traditional loan's rate. What's more, the organization retains the title to the receivables, meaning it still owns them and can classify them as short-term assets on its balance sheet. A short-term asset is a resource a company can sell -- or convert into cash -- in the next 12 months. Examples include cash, prepaid expenses and merchandise.
How It Works
The pledging process starts with department heads and corporate leadership discussing the company's funding woes, studying fund-raising alternatives to pledging and coming up with a list of account receivables to commit. Then the company's credit managers review the list with lenders, who heed the quality of the receivables -- particularly customers' payment profiles and creditworthiness, along with the length of time they've been doing business with the organization. The next step is determining the loan-to-value ratio, a metric that enables the company to receive funding but not get its way in the entire pledging process. In other words, a lender maintains some leverage in the credit process by advancing only a portion of receivables pledged. For example, an organization pledges $1 million worth of receivables and the loan-to-ratio is 75 percent. Consequently, the business receives $750,000, or $1 million times 75 percent. After determining the loan-to-value metric and signing a formal contract, the creditor files a lien on the receivables, allowing the lender to collect on the receivables if the borrower eventually defaults.
Pledging is a form of off-balance-sheet financing; that is, a company doesn't record its receivables along with the corresponding debt. This frees up capital, reduces regulatory scolding and eases the concerns of the organization's existing contingent of creditors. Receivables pledging may free up capital, because it doesn't give rise to additional debt reporting -- a boon for companies in industries, such as banking and insurance, where regulators require certain debt-to-capital ratios.
Accounts Receivable Factoring
Besides pledging, a company may factor its receivables to raise operational cash. Factoring expected client remittances means selling the receivables outright to a lender. As a result, the business cedes the receivables title to the creditor. The company notifies customers to send payments directly to the lender.