1 SMALL BUSINESS LENDING Accounts Receivable Financing for Small Business: What Makes Sense? For many bank loan and credit officers, the topic of accounts receivable financing for small business creates a certain uneasiness. After all, one of lenders worst experiences may have been the attempt to collect accounts receivable that supposedly secured a credit gone bad. While problems with other types of small business financing inventory, equipment, real estate, and so forth have been known to cause just as many bad experiences for lenders, many credit officers are more wary of receivables financing than of other small business credit products. In spite of such wariness, there are two realities of small business banking: 26 The RMA Journal December January 2001 by C. Paul Sims Jr. For small business owners, receivables financing seems a likely solution to cash flow needs; however, bankers must determine what makes sense for their institution. This article looks at receivables risk control, receivables financing products, effective product marketing, and dealing with problem situations. 1. Accounts receivable often constitute the largest asset category on small business balance sheets. 2. Banks are taking small business receivables risk every day, whether consciously or unconsciously. For those reasons, every bank that wants to capture its share of the small business market must find a way to get comfortable with accounts receivable financing each bank must determine what makes sense. Differences in Perspective To answer the what makes sense question, it is first helpful to examine the small business customer s perspective. The small business owner looks at financing needs with a sharp focus on cash flow. However, the demand on the business owner to deal with cash flow is just one of the critical pulls on his or her time sales, personnel, suppliers, and every other detail of the business also must be juggled. As a result, the business owner s perspective on cash flow is markedly pragmatic and also markedly different from that of the typical lender. When a small business owner thinks of cash flow, the thought is not about net profit after taxes plus noncash charges, or about EBIT- DA, or about any other financial definition used by lenders to measure capacity for debt repayment. The thought is about the amount 2000 by RMA and Private Business, Inc. Sims is senior vice president and director of bank services for Private Business, Inc., Brentwood, Tennessee, a company that licenses the Business Manager receivables purchase program to hundreds of banks across the country. He is also a former officer of RMA s Mid-South Chapter. Sims presented at the RMA 2000 Annual Conference.
2 of cash that will be realized through the collection of accounts receivable and flow into the business s DDA account to cover checks that must be written for accounts payable and payroll. Most financial analysis of cash flow by a lender focuses on past performance over a significant time period, with little attention paid to the accounts receivable cycle. At the same time, a small business owner s daily thoughts about cash flow are almost exclusively forward-focused on a relatively short time interval, with great emphasis on the constraints caused by having cash tied up in receivables. One of the primary goals of both lenders and business owners is cash flow predictability. Given their own definition of cash flow and shorter time horizon, however, business owners often have an intuitive acceptance of accounts receivable financing as something that makes sense in their quest for predictable daily cash flow. With many business owners expressing a need for cash flow (as they define it) and seeing a clear connection between lack of cash flow and funds tied up in receivables, what must a bank do to determine how receivables financing can make sense from the bank s viewpoint? The answer to this question is revealed by examining four decisions a bank must make: 1. How to control the risk of receivables financing. 2. What receivables financing products to offer 3. How to market receivables financing effectively 4. How to deal with problems that will sometimes arise. Controlling Risk Because most banks, whether consciously or unconsciously, are already taking risk on small business receivables, bank credit officers must ensure that their banks are following the steps necessary to be able to rely on those receivable as a source of repayment. These steps, detailed in an article by the author and Patrick True in the September 1997 Journal of Lending & Credit Risk Management, Five Keys to Relying on Accounts Receivable as a Repayment Source, are summarized below. Key #1: Make a prudent initial credit decision about the business. Regardless of the type of credit facility under consideration, this step is vital in every credit approval process. Traditional underwriting strives for a thorough understanding of the business operation and a credit facility structured within bank policy. Receivables financing, however, requires additional understanding of the characteristics of the accounts receivable, including concentrations, history of bad debt and returns/ allowances, payment terms, and potential contra accounts, among other things. Such information is not difficult to obtain, but lenders must look beyond the quantity of receivables on the balance sheet to ascertain their overall quality as well. Key #2: Maintain accurate and timely information on the receivables themselves. Unless the bank continuously knows who the account debtors are, where they are located, how much they owe, what was purchased, and the terms of sale, there is a high likelihood that the bank cannot obtain this critical information from an uncooperative business owner when a credit begins to go bad. Even banks receiving regular monthly aging reports are making a dangerous assumption that the business is continuing to generate new receivables in sufficient amounts to support the bank s exposure to replace those paid since the last report date. Key #3: Ensure control of the cash. Controlling remittances from account debtors through a bank lockbox is a critical component in relying on receivables for repayment. With remittances under the bank s control, receivables financing is a self-liquidating credit facility. With remittances flowing from account debtors back to the business, the risk is high that a business will not be disciplined enough to use the funds purely for working capital, resulting in a credit facility that does not revolve or eventually has to be termed out. Key #4: Establish effective monitoring procedures. Accounts receivable are typically the fastest-moving noncash asset on a small business balance sheet. Defined procedures must therefore be in place to monitor both receivables quantity and quality on an ongoing basis. These procedures should include periodic verification of receivables with the account debtors, regular review of available information, appropriate adjustment of advance rates or required reserves, and keeping a vigilant eye on potential red flags that might indicate a problem. Clear assignment of these 27
3 responsibilities is critical so that potential problems are investigated promptly and warranted action taken without delay. Key #5: Protect against changing credit circumstances. If banks always made good initial underwriting decisions and credit circumstances never changed, loan losses would be miniscule. Because that is fantasy, however, banks relying on receivables must manage their relationships in a forwardthinking way. They must be alert not only to changes in the business being financed, but to changes that affect the quality of the account debtors and to changing cash flow pressures that may tempt a business owner to divert funds or submit fraudulent receivables information. While effective use of Keys 2 through 4 above will help in this regard, banks also should consider nontraditional types of protection, such as accounts receivable credit insurance and insurance against business fraud, neither of which is covered by banks blanket bond policies. What to Offer Banks take small business receivables risk in four primary ways blanket lien lines of credit, Types of A/R Financing Compared 2000 by Private Business, Inc. All Rights Reserved Blanket Lien Line of Credit Bank-Based A/R Purchase Program Asset- Based/Borrowing Base Lending Factoring Typical bank marketing strategy little marketing; what customers usually ask for targeted, needs-based approach targeted, needs-based approach generally targeted, but to lower quality credits Sold to business primarily on basis of interest rate benefits to the business of improved cash flow interest rate limited options available to the business; ease of access to cash Relationship orientation very relationship-oriented very relationship-oriented very relationship-oriented more transaction-oriented Product differentiation little differentiation; everybody has it becoming more common; perceived as differentiated little differentiation still a somewhat tainted market perception Funds available to the business typically 60%-75% of eligible A/R typically 80%-90% of eligible A/R typically 80%-90 of eligible A/R typically 75%-90% of eligible A/R Control over credit risk usually very unstructured and loosely monitored well-defined risk controls and monitoring procedures some structure, but timeliness is an issue defined controls over certain A/R Business's liability for repayment direct liability contingent liability direct liability contingent liability or no liability Eligibility of newly created A/R typically no eligibility criteria all typically eligible, except affiliates, contras, and foreign all typically eligible, except affiliates, contras, and foreign only accounts that factor has underwritten are eligible Eligibility of aged A/R typically no monitored eligibility criteria repurchase typically required at > 90 days typically exclude from borrowing base at > 90 days either hard collection activity or repurchase at days Typical repayment plan supposedly revolving, but often termed out revolving and self-liquidating revolving; sometimes termed out revolving and selfliquidating Impact on business's customer relationships A/R information available to business minimal none minimal or positive if bank's presence speeds payment extensive information minimal none minimal or negative if factor undertakes hard collection limited information 28 The RMA Journal December January 2001
4 B ANKS OFTEN DELUDE THEMSELVES ABOUT THE PROTECTION AFFORDED BY A BLANKET LIEN. THEY ASSUME THAT SECURED BY IS THE SAME THING AS SECURE A BAD ASSUMPTION WITHOUT THE STRUCTURE, DISCIPLINE, AND MONITORING INHERENT IN A RECEIVABLES PURCHASE PROGRAM OR TRUE ASSET-BASED LENDING. bank-based receivables purchasing programs, asset-based or borrowing-based lending, and traditional factoring. Any given bank may well offer more than one of these accounts receivable financing products, but the bank s choices should be made consciously, since each product has differing characteristics, both from a credit and a business development standpoint. The matrix on the opposite page, Types of A/R Financing Compared, points out these differences and the characteristics outlined below. Banks take most of their accounts receivable financing risk in blanket-lien lines of credit. These credit facilities, in reality, are heavily dependent on receivables for repayment; however, many are underwritten without regard to the five keys discussed earlier. As a result, such lines of credit may be the riskiest of all forms of receivables financing. The danger here is that banks often delude themselves about the protection afforded by a blanket lien. They assume that secured by is the same thing as secure a bad assumption without the structure, discipline, and monitoring inherent in a receivables purchase program or true asset-based lending. In addition, blanket-lien lines of credit are more prone than the other three products to what might be called the big lie concerning repayment. The big lie refers to the standard assertion by lenders on many line-of-credit approval write-ups that the primary source of repayment is the conversion of current assets through the operating cycle into cash. The conversion cycle obviously does take place; without controlling the cash generated by account debtor remittances, however, the bank is more likely to be repaid from either a term-out of the debt or a take-out by another lender. Bank-based accounts receivable purchase programs are com - mon among community banks and some regional banks and are typically offered in alliance with a vendor who provides the bank with business development support and a sophisticated system for tracking and managing the receivables. Although more structured than lines of credit, such programs are targeted to businesses of average acceptable credit quality and sold on the basis of cash flow benefits to the business. Because of the credit structure and risk controls, the effective advance rate against receivables in such a program averages 82-85%, versus a typical line of credit advance rate of 60-75%, and is comparable to an asset-based lending advance rate. Used properly, however, a receivables purchase program results in greater bank profitability and more knowledge than usual of the small businesses financed as customers. Such a program is also designed around the five keys discussed earlier and offers significant ability, when properly executed, to monitor and control risk in a systematic, disciplined way. Asset-based lending and/or borrowing-based lending is used with varying levels of formality in a significant percentage of both community and regional banks. On the more formal side, fulldominion asset-based lending departments are common in regional banks, but the small business market segment is usually below the radar of such operations, whose typical preferred credit size is more than $1 million. Most community and regional banks without an ABL department, however, offer less formal borrowingbased lending to their small business customers, typically with monthly reporting requirements and borrowing-based certificates. Both asset-based lending and borrowing-based lending offer more potential for adequate risk control than do blanket-lien lines of credit, but outside of full dominion ABL departments, many generalist lenders lack both the time and the timely information necessary to monitor such relationships through the inevitable changing of credit circumstances. 29
5 M ARKETING OF RECEIVABLES FINANCING CAN OFTEN BE ACCOMPLISHED MORE EFFECTIVELY, HOWEVER, WHEN LENDERS VIEW IT AS A DISTINCT CASH FLOW SOLUTION AND POSITION IT AS SUCH IN THE EYES OF THE BUSINESS OWNER. The traditional factoring product, while sometimes offered through subsidiaries of large or superregional banks, is still principally the domain of commercial finance companies and specialty factors. Traditional factoring can be utilized in a relatively riskcontrolled way for the business segment it serves; however, because it is offered by so few banks and still retains some credit-quality stigma among both lenders and business owners outside of certain industries, it will not be considered further in this article. Given the popularity among many banks of a credit scored product for small businesses, one might ask what role credit scoring plays in the accounts receivables financing decision. To date, the answer for most banks appears to be little or none. It may be desirable for the sake of data collection consistency to produce a credit score for each small business applicant. However, for banks that use scoring to decision credits, the amount of credit granted may be based more on the parameters of the bank s model and the relatively low approval limits set by credit policy than on the actual financing needs expressed by the business. For example, a bank may offer maximum $50,000 or even $100,000 credit-scored lines by policy, but for the business with a $150,000 financing need and the receivables to support it, the creditscored line provides only a partial solution. The fact is that many small businesses have working capital financing needs that cannot be underwritten on an unstructured basis, but those businesses represent very bankable risks within the structure of an accounts receivable facility. Effective Marketing The typical small business owner, when pursuing a financing request, will almost invariably say that he or she needs a line of credit, regardless of how the funds will be used or what the true financing need of the business is. Lenders are typically quick to accept the business owner s stated need. As a result, many lenders tend to view accounts receivable financing purely as a matter of credit structure rather than as a distinct product with its own advantages to offer the business owner. Such behavior plays a large part in explaining why banks wind up taking most of their receivables risk in the form of blanket-lien lines of credit it is the product of least resistance for both business owners and lenders. Marketing of receivables financing can often be accomplished more effectively, however, when lenders view it as a distinct cash flow solution and position it as such in the eyes of the business owner. Banks that offer a receivables purchasing program or maintain an asset-based lending department tend to subscribe to this approach. Their business developers wisely seek to uncover a business owner s vision for his/her company and how the lack of cash flow is constraining the realization of that vision. Such an approach focuses the business owner on the cash flow benefits of using receivables financing to capitalize on business opportunities that would otherwise be lost. At the same time, this approach of emphasizing benefits to accomplish the owner s goals gives the bank something that most banks find elusive a basis other than pure price competition on which to sell its product. When properly executed, there is an additional benefit to the bank of marketing its chosen receivables financing products in this way. Discussion with a business owner of his or her accounts receivable cycle and cash flow (as defined by the owner, not the lender) tends to reveal all the financial needs of the business, regardless of whether receivables financing makes sense at that time or not. For alert lenders, the marketing of receivables financing can open the door to deeper understanding of the business operation and to the sale of other bank products and services as a result. Dealing with Problems If a bank is going to rely on receivables as a repayment source 30 The RMA Journal December January 2001
6 to get its share of the small business market, it must take seriously the five keys mentioned earlier. Just as with any form of financing, however, a problem will arise occasionally and must be dealt with effectively in order to minimize exposure. In receivables financing, such problem situations typically arise for one of three reasons: 1. The business may not perform as expected. Management makes bad decisions, projected sales fail to materialize, issues arise with product or service quality these and other problems plague businesses and their bank regardless of whether or not receivables are being financed. 2. More specific to receivables financing, the account debtors owing the receivables may not perform as expected. They have cash flow problems of their own, they overextend themselves, they stretch out payments such problems with account debtors become apparent quickly if the receivables are analyzed regularly. 3. Perhaps less defensible than the first two reasons, the bank may not underwrite and control its risk well. The lender does not understand the characteristics of the receivables, the bank does not monitor receivables effectively, ongoing financing decisions are not well reasoned in such cases, the bank is typically just not executing well on the basics. Banks that do a good job of understanding and monitoring receivables can usually focus clearly on the red flags caused by underperforming businesses and underperforming account debtors. When such warning signs are spotted, they must be investigated immediately for significance. If the situation does turn out to be a problem and warrants further action, verification of the receivables with the account debtors is the crucial step in quantifying the bank s exposure. The verification process not only quantifies what account debtors believe they owe, it also reveals whether the business has submitted false invoice information or has diverted funds, two of the principal risks in any type of receivables financing. Formulating a plan (with advice of counsel) to notify account debtors of the bank s position is often the most effective way to begin resolving the problem. Even if largely ignored by the bank up to that point, controlling the remittances from account debtors and diligently monitoring both new sales activity and the existing receivables are critical to a successful resolution. Dealing effectively with a problem situation in receivables financing often requires a firm but pragmatic approach and an open mind to get a business refinanced elsewhere or to realize maximum value in actual collection of the receivables. Summary With every bank wanting to grow its share of the small business market segment and with receivables constituting the largest asset category on many small business balance sheets, banks are constantly taking accounts receivable credit risk, whether consciously or unconsciously. Since receivables financing often makes sense to small business owners as a solution to their perceived cash flow needs, the challenge is for bankers to determine what makes sense for their institution how to control receivables risk, what receivables financing products to offer, how to market those products effectively, and how to deal with problem situations that occasionally arise. Those banks which take the appropriate steps to rely on receivables as a repayment source, which utilize and market the different receivables financing products actively, and which handle problem situations effectively will reap the rewards of greater penetration and greater profitability in their small business market segment. Sims can be contacted by at 31