Receivables Financing Goes Respectable

Today's economic climate has turned a last-resort form of financing into a legitimate business tool.

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By 1972, United American Food Processors Inc. had made a name for itself, shipping a little more than half a million pounds of prime and choice meat each month to some of the finest hotels and restaurants in the United States. But the company wasn't able to grow. It lacked the capital necessary to boost inventories.

Borrowing from the bank was out, since that institution didn't like lending money for the purchase of large quantities of beef and pork -- perishables whose price varies from week to week. As Gerald Kolb, United American's treasurer, says of those days, "We were financially strapped by the limitations the bank placed on us."

The answer for the company, which makes its home in Chicago's stockyards, was accounts receivable financing, a technique it still uses. United American started by borrowing a percentage of the total of its receivables from a finance company, then repaying the loan by endorsing and forwarding checks it received from its customers to the finance company. It secured additional capital from the same company by borrowing money on invoices generated on new orders, then it repaid those amounts in the same fashion as it had the initial loan.

The finance company's principal requirement was that United American keep the amount it borrowed to 90% or less of the total of its receivables on any given day. The company didn't mind this restriction because that figure came to a hefty $2 million, a sum that enabled United American to purchase additional inventories, improving its ability to handle new customers and to protect itself against scarcities and price fluctuations.

The end result for United American was a substantial increase in revenues (the company's sales jumped from $15 million in 1972 to $43 million in 1982). The finance company wasn't responsible for our business tripling," Kolb says, "but they are responsible for making available the funds by which we were able to accomplish that."

While most businesses won't double their revenues by financing their receivables, they can expect to improve their cash flow. That is because receivables financing gives companies access to funds that are unavailable to them during normal collection periods -- 30, 60, Sometimes 90 days.

For a growing number of corporations, that availability is a real plus. "You've got to remember that the liquidity of major companies as well as smaller companies has been strained by the poor economic conditions," says Joseph A. Pollicino, executive vice-president of Manufacturers Hanover Commercial Corp. in New York. His company's receivables-financing business has tripled in the past three years.

Growth in receivables financing also is reported by Walter E. Heller & Co., a commercial finance company based in Chicago. There, the big increase is in the use of receivables financing for leveraged buyouts and business expansion, says Maynard I. Wishner, president and chief executive officer. He attributes this increase to a change in attitudes -- receivables financing is no longer viewed as last-resort financing but as a legitimate business tool.

By definition, receivables financing is a "loan against money owed" to a company by its customers. "Receivables financing is a method of secured lending, also known as asset-based financing," explains John R. Holding, vice-president of marketing for Walter E. Heller. "Funds are available continuously in proportion to the accounts assigned as security. There are no fixed maturities. In an accounting sense, it is short-term borrowing. In concept, it's long term, according to the desire of the borrower."

Accounts receivable financing is provided under a contract between the lender and the borrower. The agreement usually covers a period of one to three years and is automatically renewed unless one of the two parties cancels it. The amount lent ranges from 50% to 100% of the value of the receivables. As a rule, customers aren't told that the company they buy from is financing its receivables (although their checks are sometimes deposited in the lender's account), but customers are sometimes contacted as part of the "audit verification process."

Corporations most likely to benefit from accounts receivable financing are those unable to get traditional bank credit. "So are companies that are short of capital, companies that have large loan fluctuations because of the seasonality of their business, companies in a high-growth mode, and companies that can't clean up a bank loan," notes Pollicino of Manufacturers Hanover. He says this list includes distributors, home building suppliers, and apparel businesses.

One drawback to receivables financing is the paperwork. Finance companies usually require that their customers provide daily or weekly lists of their accounts receivable, and they conduct audits or field examinations every two to three months. They watch receivables closely, declaring those that are more than 90 days old "ineligible" -- an incentive for corporations financing their receivables to keep their accounts current.

Another drawback to receivables financing -- and perhaps the biggest one -- is its cost. Heller, Manufacturers Hanover, and Armco Commercial, a division of Armco Financial Corp. in Englewood Cliffs, N.J., charge their customers an average of prime plus two, three, or four percentage points, but some finance companies have imposed rates as high as eight percentage points over prime.

The cost of receivables financing is played down by lenders and their customers. They argue that accounts receivable financing is no more expensive than a bank loan, citing in particular "compensating balances," the minimum portion of a line of credit a bank expects its customer to keep on deposit.

"Although the stated rate of 'prime plus' may be higher, there are no hidden costs, such as compensating balances, which alone increase the effective cost as much as 20%," says Richard J. Tucker, president of Armco. "Furthermore, conventional bank loans are geared to peak cyclical requirements, whereas accounts receivable loans fluctuate daily, and thus reflect average requirements. The difference between peak and average can add 10% to 20% to the cost of a conventional bankloan."

Similar points are made by two of Armco's customers -- Thomas Kroblin, vice-president of Kroblin Refrigerated Express Inc. in Tulsa, and Samuel Goldman, chairman of the Stranahan Foil Co. in South Hackensack, N.J. "When you talk about the cost of funds," notes Kroblin, "you must consider more than the lending rate. You have to consider the cost of compensating balances the banks may require you to maintain and the collateral requirements of a loan." Says Goldman, "The convenience and the ready access to funds makes it worthwhile."

But others disagree. Why borrow from a finance company rather than a bank? "You borrow from the finance company because you can't borrow from the bank," notes Ronald S. Itzler, a partner in the law firm of Ballon, Stoll & Itzler, who has represented both finance companies and their clients.

For those businesses considering receivables financing, here are five tips:

1. Talk to your banker. Many banks now provide accounts receivable financing on their own or through a cooperative arrangement with a finance company. United American, for example, finances its receivables with Walter E. Heller, in partnership with American National Bank & Trust Co. of Chicago. Those banks that don't provide receivables financing will usually refer you to a reputable finance company. Other sources of information on receivables financing are accountants and attorneys.

2. Compare rates. The rate you pay for receivables is determined by the lender's analysis of your financial status, the market, and the nature of the finance company. One finance company's opinion of the credit worthiness of your receivables may vary from another's. Also, keep in mind that finance companies aren't charging as much as they once did for receivables financing. One reason is the sluggish economy; another is growing competition within the industry. "Right now, the financing business is not ver good," notes Itzler. "Sales are down, and when sales are down there is less borrowing." Consequently, you may secure a better rate if you shop around.

3. Negotiate. The terms of accounts receivable financing vary from lender to lender. Rates, repayment procedures, an the length of the contract are all negotiable. Keep in mind, though, that most of the major finance companies impose minimums; $500,000 is the figure mentioned most often. They go below this level on occasion (companies with high growth potential are candidates), but you should try a regional finance company or your bank if you are seeking a much smaller amount.

4. Ask questions. Some finance companies specialize. Armco Commercial, for instance, likes to lend money to companies in service industries. "The accounts receivable of service companies are far easier to monitor because you have proof of the service performed," says Armco's Tucker. "With a manufactured product, you always have ongoing exposure. Maybe the goods were defective. Maybe you'll get returns down the road. Services don't get returned."

5. Don't hire an outside auditor. Companies providing receivables financing generally don't require outside audits, so save yourself the expense. "We don't insist that our borrowers have outside audited financial statements purely for our benefit," says Tucker. "We have our own Big Eight-trained field examiners who go out and do an examination for our purposes."

Finally, consider factoring as an alternative to receivables financing. With receivables financing, the finance company takes a lien or security interest in the receivables. With factoring, it purchases the accounts outright. If your customers are slow to pay on their accounts, factoring may be desirable.