# Monetizing Accounts Receivable into Cash

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1 Monetizing Accounts Receivable into Cash How finance executives can protect against extended payment terms and improve their working capital in an online marketplace WP White Paper

3 Page 3 The Cost of Accounts Receivable to Companies Figure 1 shows giving up 44 days worth of return is extremely costly for a company. The opportunity cost associated with holding long-dated accounts receivable on a balance sheet can be measured by the lost Return on Equity (ROE). The example given illustrates this loss. Had the company received cash immediately for the sale of its goods and services, the money could have been reinvested in the business and earned the company marginal return on equity. By not monetizing its sale, but creating a receivable outstanding for 44 days, the opportunity cost is 2.22%. The faster a company can receive cash for its accounts receivable, the quicker it can reinvest and grow operations. Figure 1 If a company can earn 20% on the money it invests in itself, then in 44 days it can earn a 2.22% return. 44 \$100 x = \$100 x = \$ The appropriate measure for the efficiency with which a company manages its working capital is called the Cash Conversion Cycle (CCC). Figure 2 Cash Conversion Cycle = Days Sales Outstanding + Days Inventory Outstanding Days Payable Outstanding The Cash Conversion Cycle (CCC) (Accounts Receivable) DSO = x 365 (Total Credit Sales) (Inventory) DSI = x 365 (COGS) (Accounts Payable) DFO = x 365 (COGS) The cash conversion cycle is the number of days between when a company pays for materials and when it receives cash for the sale of goods made from those materials. In Figure 3, we assume that a company sells \$300,000 of receivables (note the change in cash and accounts receivable).

4 Page 4 Figure 3 Amount of A/R Sold 300,000 5 Discount 2% \$ Discount 6,000 Before After Balance Sheet Cash 50,000 add A/R sold - \$ Discount 344,000 Account Receivable 400,000 A/R declines by amount sold 100,000 Inventory 400, ,000 S-T Securities 150, ,000 Total Current Assets 1,000, ,000 Current Liabilities (Account Payable) 300, ,000 LT Liabilities 200, ,000 Shareholders Equity 500, ,000 Total Liabilities and Shareholder Equity 1,000, ,000 Days Sales Outstanding 29 7 Days Inventory Turnover Days Accounts Payable Turnover After selling the receivables, the company has excess cash that it can invest in operations. Companies choosing to monetize their accounts receivable see multiple capital efficiencies such as: An improved Cash Conversion Cycle, in this case by 22 days. Reduced Days Sales Outstanding (DSO). Working capital previously tied up for months can be used to expand operations. Capital that begins earning a return for the business in a matter of days. Once a receivable is sold, the cash can be reinvested in new inventory, products, employees, or anything that will earn a positive return for the company. The transaction has now become an accretive decision for the business. Figure 4 3) Source: Standard and Poor s, Hedgefund.net

5 Page 5 In Figure 4, the longer it takes a company to convert its materials to cash, the lower the company s return on equity. Having working capital tied up in accounts receivable limits business performance. Wall Street s Interest in Account Receivable Figure 5. Wall Street firms deploy capital in a variety of ways. Fundamentally, the firms seek to maximize their return on any investable asset for a given level of risk. In other words, the objective is to realize the best returns on a particular investment based on the risk associated with that investment. To measure risk, Wall Street firms analyze the historical volatility of potential assets. They also analyze an asset s correlation to other assets in their portfolio. They use this process of diversification to construct portfolios of non-correlated assets. Mixing a variety of investments in a portfolio will, on average, yield higher returns and bear lower risk than any single investment or group of highly correlated investments. Like with most other asset classes, Wall Street firms can identify and quantify the risk inherent in companies accounts receivable. Historically, an investment in the returns of a company s accounts receivable has provided a very steady return. (In Figure 6, Hedgefund.net s Asset-Based Lending (ABL) Index is used as a proxy for the returns of accounts receivable). Figure 5 shows this return is almost the same as the historical return of the S&P 500 s stock index. Notice, however, that the volatility, as measured by Beta, is considerably lower. Graphically, the ABL Index s lower volatility is evident by the consistent nature of its line plot, as compared to that of the jagged ups and downs of the S&P 500 s. This suggests that the return profile of accounts receivable is uncorrelated with the general market. This characteristic makes an investment in accounts receivable very appealing to Wall Street firms. Figure 6 ABL S&P 500 Annualized Returns since % 11.4% Capital Structure Asset-Based Equity Beta Figure 5 RISK OVERVIEW: Risk A measure of the probability of a known loss occurring. Diversification A risk management technique that mixes a wide variety of non-correlated investments within a portfolio; the positive performance of some investments will neutralize the negative performance of others. Correlation A measure of the strength and linear relationship of two variables (measured from -1 to 1); two assets that are perfectly correlated (1) will move in the same direction in the same increment; two assets that are perfectly negatively correlated (-1) will move in opposite directions in the same increment. Beta A measure of volatility of an asset relative to the overall market. 40% 30% 20% 10% 0% -10% -20% -30%

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