If you are an owner of a small enterprise or a financial controller in a large corporation, they are various ways of financing your accounts receivables. Before plunging into the dynamics of receivable financing, it would be prudent to start from current assets. Receivable financing, in essence, is the credit amount that you will receive from the buyer after a periodic time. The reason why business owners choose sales on cash and credit is twofold. First, the other party will not pay for the product or services which you have provided. However, in extending credit, you will always factor in the price differential into the total credit amount, keeping in mind the concept of the time value of money. Secondly, it is considered a sign of long-term commitment with buyers, especially in this cutthroat competition era. If you pay close attention to the financial world, you will instantly understand that an increase in receivable is an outflow of cash, despite the fact you have made a sale.
Eventually, there will come a time when you will be required to bridge the gap arising from working capital requirements. To determine net working capital requirement, all you need to do is simple math like Days Receivable + Days Inventory – Days Payable =Net Working Capital Cycle. The calculation will help you understand how efficiently and quickly you are able to churn the credit outstanding into real cash. Ideally, you can finance the receivables of your company in two ways. First, you can seek financing through internal resources by matching the amount and number of days against days payable, equating seeking credit purchase with extending credit sale. In the second approach, you can always resort to external sources. They may include banks, other financial institutions, or non-banking channels. It is of paramount importance that you avoid your business transactions from all kinds of hard money or loan sharks.
When it comes to financial institutions, you will come across relationship managers that will offer you two types of receivable financing facilities. One will be structured and regulated, and the other will be in the form of a simple overdraft or running finance facility. Let’s try to keep you abreast of the structured receivable financing facility, which is commonly known as Invoice Discounting.
In invoice discounting, as the name implies, for any sale that you have made to any company for any amount, you will generate an invoice for the purpose of proper bookkeeping. You simply do that at the time of sale; you get the sale invoice signed by the buyer, which mentions that the total amount will be paid within the stipulated terms and agreement. Once the buyer signs it, you go to your financial institution and get the invoice assigned. In other words, this process is also known as Assignment for Receivables (AFR). Next is the bank discounts the invoice, giving about 90% of the invoice amount back to the company. When the invoice reaches maturity, the remaining amount is credited back to the company’s account after deducting the interest rate payment. The interest rate or spread rate depends on the obligor risk profile of both the buyer and the company. The bank, at the time of discounting the invoice, takes a guarantee in the form of AFR, which means that on the maturity date, the buyer will write a check or a pay-order that will be in favor of the company but assigned to the bank, where the company is maintaining its account and had the invoice discounted. For large-tier organizations, this is a routine process, and it is built into their process of ERP (Enterprise Resource Planning) and automated bookkeeping.
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