Wednesday, January 7, 2009

Entrepreneur Guide to Business Financing Sources - Secured Financing. Business Funding Solutions Using your Accounts Receivable and Inventory.

After showing you some unsecured financing sources on previous post, now let's turn to secured financing sources.

Secured Financing

Secured financing is "backed" by collateral of some specific asset or assets of the borrower. The collateral acts as a backup source of funds for the lender if the borrower fails to abide by the terms of the loan. The collateral for short-term financing arrangements is usually current assets—marketable securities, accounts receivable, or inventory. Below we will describe two types of secured financing arrangements: accounts receivable financing and inventory financing.

1) Accounts Receivable
Accounts receivable can be used as collateral for a secured loan. There are three types of financing arrangements that use accounts receivable as security: assignment, factoring, and securitizing. Securitizing assets, also referred to as asset securitization, is an important financing arrangement for raising short- to intermediate-term funds. In the next chapter we discuss the process of asset securitization.

The simplest form of accounts receivable financing is the assignment of receivables. In an assignment of receivables, the lender makes a loan accepting the borrower's accounts receivable as the collateral. The borrower receives immediate cash in exchange for a promissory note to the lender. This type of financing may be either a non-notification or a notification plan. In the case of a non-notification plan, customers pay the company and the company in turn pays the bank. In the case of a notification plan, the borrower's customers are generally instructed to send their payments to the lender, who uses these payments to reduce the amount of the loan. This type of financing is flexible since the lender increases the loan as more receivables are generated (as acceptable collateral by the borrower) and reduces the loan as these receivables are paid off. Therefore the borrowed amount fluctuates with the needs of the borrower.

A borrower can go a step further in financing with accounts receivable. Instead of simply using accounts receivable as collateral, the borrower can sell them outright to another party—called a factor—typically a bank or a commercial finance company. Selling the receivables—called factoring—may be done with or without recourse. In a factoring arrangement without recourse, the factor performs all the accounts receivable functions: evaluating customers' credit, approving credit, and collecting on accounts receivable. If any of the accounts turn out to be uncollectible, the factor bears the bad debt. If a borrower has an arrangement with a factor with recourse and the borrower grants credit without permission from the factor, the borrower assumes responsibilities for collection of the account.

There are basically two types of factoring, maturity factoring and conventional factoring. They differ with respect to when cash is received for the receivables. In maturity factoring, the customer sends cash to the factor, who then sends the cash (less a commission) to the seller. In conventional factoring, the factor advances cash to the seller when the accounts are factored, and then keeps the customers' payments as they come in. Because factoring is a substitute for having accounts receivable personnel, whether a CFO should use factoring requires comparing what it costs to operate the receivables function with the factor's commission.

2) Inventory
Inventory can also be used as collateral for financing since it is a fairly liquid asset. Not all inventory is of equal importance as collateral: The amount of funds loaned depends on how easy it is for the lender to turn the inventory into cash. In general, (1) standardized inventory is much better than specialized inventory, (2) nonperishable inventory is better than perishable inventory, and (3) raw materials and finished goods are better than work-in-process.

There are several different types of loan arrangements that involve inventory as collateral. These arrangements differ in terms of the control that the lender has over the location and disposition of the inventory. A floating lien is the most flexible type of inventory loan. A floating lien gives the lender a lien on all inventory of the borrower—that is, all inventory is collateral for the loan. Therefore the collateral for the loan changes as the borrower buys and sells inventory.

A chattel mortgage is a loan secured by specified inventory. In other words, inventory items are uniquely identified, such as by serial number, as collateral for the loan. The borrower retains title of the inventory. And although the borrowing firm still owns the inventory, it cannot sell the inventory unless the lender gives permission. This type of loan is best suited for inventory that consists of large, slow-moving items.

In a trust receipts loan, the borrower holds the inventory in trust for the lender. As the inventory is sold, the borrower keeps the proceeds in trust for the lender. This type of arrangement is also referred to as floor planning and is used often with auto dealerships and other types of inventory in which the merchandise is serial numbered. First, the borrower arranges a loan with the finance company. The borrower then orders and receives the inventory, with the finance company paying the supplier. As the borrower sells the inventory items, the borrower remits the payments to the finance company, reducing the amount of the loan. Because the finance company is counting on the borrower to maintain the inventory (keep it in good condition) and send the payments when sales are made, the lender must devise a way to monitor the borrower.

In a field warehouse loan, the lender has tighter control over the inventory. The collateral (the inventory) is kept in a separate, secured area within the borrower's premises and is monitored by a field warehouse agent. This agent keeps control over the inventory in this area and issues receipts to the lender, indicating the existence of the inventory. As the lending entity receives these receipts, it makes a loan based on the collateral value of the inventory. This arrangement is more expensive than the floating lien, chattel mortgage, and trust receipts arrangements because a third party—the field warehouser—must be compensated for the services provided. This arrangement offers the lender more peace of mind over the inventory.

Even tighter control over collateral inventory is maintained in a public warehouse loan arrangement. In a public warehouse loan, collateral inventory is kept in a secured area away from the borrower's premises, such as in a public warehouse, and is only released to the borrower if the lender gives permission. The warehouser issues to the lender receipts (similar to the field warehouse arrangement) from which the lender acknowledges in the form of money loaned to the borrower. In this arrangement, the lender has title to the goods instead of the borrower.

Loan-To-Value for Secured Financing
In financing arrangements secured with accounts receivable, the lender will often limit the amount of financing to a specified percentage of the value of the collateral, measured by the loan-to-value ratio. For example, in the case of accounts receivable, the loan-to-value ratio may be 75% of the anticipated collections on accounts outstanding up to 30 days, but 60% for accounts outstanding 31 to 60 days. In the case of inventory, a lender may specify a loan-to-value ratio of 60% of finished goods, but 30% of raw materials or work-in-process inventory.

For more Information:
Business Finance Resources
Best Practices for Financial Advisors, Guide for Growing Business, Corporate Finance Handbook


1 comment:

  1. Very good information about the mortgage topic as people face the problem due to lake of information. I specially admire your effort for inventory.


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