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What is The Importance Of Analyzing Accounts Receivable. Accounts Receivable Financing : An alternative to bank financing for your small business DISCUSS THE ABOVE STATEMENT BY TAKING EXAMPLE OF BUSINESS ORGANIZATION OF YOUR CHOICE.

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Importance of Analyzing Account Receivable

In studying financial statements, investors often focus on revenues, net income, and earnings per share. Although investigating a business’s revenues and profits is a good way to get a picture of its overall health, analyzing the accounts receivable allows you to go a step deeper in your analysis.

In the simplest terms, accounts receivable measures the money that customers owe to a business for goods or services already provided. Because the business expects the money in the future, accountants include accounts receivable as an asset on the business’s balance sheet. . However, most businesses do not expect to collect 100 percent of the money shown in accounts receivable.

Given this risk of non-payment, why do business continue providing goods and services without requiring payment in advance? When dealing with regular and reliable customers, a business can benefit from selling its goods and services on credit. It may be able to make more sales that way and also reduce transaction costs. For example, the business can invoice reliable customers periodically instead of processing numerous small payments.

The problem is when accounts receivable reflects money owed by unreliable customers. Customers can default on their payments, forcing the business to accept a loss. In order to account for this risk, businesses base their financial reporting on the assumption that not all of their accounts receivable will be paid by customers. Accountants refer to this portion as the allowance for bad debts.

On face value, it is impossible to know whether the accounts receivable of a business are indicative of healthy or unhealthy business practices. Investors can only gain this knowledge through careful analysis.

Account Receivable Financing

Using your accounts receivable, or your customers’ credit accounts, to obtain financing for your small business is another method of raising money for working capital needs. Both accounts receivable financing and inventory financing are usually used for quick, short-term loans when it is not possible to obtain a short-term loan from a bank or other financial institution. Both are used to raise working capital or the money you use for your daily operations

Accounts receivable financing or factoring can also be used as an alternative to bank financing.

Commercial finance companies often offer accounts receivable financing to small business firms. Sometimes, commercial banks or other financial institutions will also offer accounts receivable financing. Interest rates are usually higher on this type of financing than on a traditional bank loan.

There are two methods of accounts receivable financing.

1. Pledging Account Receivable

Pledging, or assigning, accounts receivable means that you essentially use your accounts receivable as collateral to obtain cash. The lender has the receivables as security, but you, as the business owner, are still responsible for the collection of the debts from your credit customers.

A lender looks at the aging schedule of a business firm’s accounts receivables in determining which ones to accept as collateral. Usually, the lender only accepts those receivables that are not overdue. Overdue accounts don’t make good collateral. Also, if a customer has credit terms extended to them that the lender thinks are too long, the lender may not accept those particular receivables either. After examining a company’s receivables for overdue accounts and terms the lender doesn’t like, the lender then determines what amount of the company’s receivables they will accept.

After that, the lender will typically adjust that amount for returns and allowances. At that point, they will decide what percentage of the value of the acceptable receivables they will loan and make the loan to the small business. The percentage they will loan is usually around 75-85%.

If the small business defaults on the loan, the lender then takes over the company’s accounts receivables and collects on the debts themselves.

Factoring Account Receivable

Factoring your accounts receivables means that you actually sell them, as opposed to pledging them as collateral, to a factoring company. The factoring company gives you an advance payment for accounts you would have to wait on for payment. The advance payment is usually 70-90% of the total value of the receivables. After charging a small fee to the company, usually 2-3%, the remaining balance is paid after the full balance is paid to the factor.

Factoring is a relatively expensive source of financing, but the cost is lowered because the factoring company takes on all risk of default by the customer.

Factoring is important in the retail industry in the U.S. In fact, the garment industry accounts for about 80% of all U.S. factoring, although many small businesses in a huge variety of industries use this form of financing when they need short-term working capital loans.

Sometimes using accounts receivable financing is all that stands between your small business and bankruptcy, particularly during a recession or other types of tough times for your business. Don’t hesitate to use it for your working capital needs if you need to. It is not acceptable financing, however, for longer-term business financing needs.

Example

Let's say Company XYZ sells widgets. It has about $1 million in receivables from customers who have not paid for their widgets.

Company XYZ needs cash right away because it is trying to finish building a factory. A/R is an asset, and as such, it appears on the balance sheet. In particular, A/R is a current asset, meaning that the amount owed is expected to be received within the next 12 months.

Company XYZ calls a factor, which purchases the receivables for $750,000. In the deal, Company XYZ gets $750,000 right away, and the factor gets the right to all the money from the receivables ($1 million). A factor is a financial institution that purchases receivables from a company. The factor then assumes the risk of customers paying late or not paying at all.