Entrepreneurship, Second Edition

11.6. Obtaining Bank Loans Through Accounts Receivable Financing

One approach to free up working capital funds is to convert accounts receivable into cash more quickly through aggressive collection techniques. However, if you fear aggressive collection may offend customers and cause them to take their business to competitors, you may decide to convert accounts receivable to cash through a financing company, using either pledging or factoring. The following sections describe both methods. In practice, finance companies and banks offer many variations on them.

11.6.1. Pledging

Pledging means using accounts receivable as collateral for a loan from a finance company or bank. The finance company then gives money to the borrower, and as the borrower's customers pay their bills, the borrower repays the loan to the finance company. With this form of accounts receivable financing, the borrower's customers are not notified that their bills are being used as collateral for a loan. Therefore, pledging is called non-notification financing. Furthermore, if customers do not pay their bills, the borrower (rather than the finance company) must absorb the loss. Thus, if the customer defaults, the lender has the right of recourse to the borrower.

A finance company will not usually lend the full face value of the accounts receivable pledged. Typically, a company can borrow 75% to 90% of the face value of its accounts receivable if it has a good credit rating and its customers have excellent credit ...