Tag Archives | accounts receivable

Collection Effectiveness Index (CEI)

See Also:
CEI vs. DSO
Key Performance Indicators (KPI’s)
How Does a CFO Bring Value to a Company?
5 Stages of Business Grief

Collection Effectiveness Index (CEI)

The Collection Effectiveness Index, also known as CEI, is a calculation of a company’s ability to retrieve their accounts receivable from customers. CEI measures the amount collected during a time period to the amount of receivables in the same time period. In comparison, the collection effectiveness index is slightly more accurate than daily sales outstanding (DSO) because of the time period. A company’s CEI can be calculated for any amount of time, small or large. Conversely, DSO is less accurate with shorter time periods, which is why DSO is calculated every 3 to 6 months.

The Collection Effectiveness Index Formula:

Collection Effectiveness Index

The formula consists of the sum of beginning receivables and monthly credit sales, less ending total receivables. Then, divide that by the sum of beginning receivables and monthly credit sales, less ending current receivables. The value is then multiplied by 100 to get a percentage, and if a CEI percentage is close to or equals to 100%, then that means that the collection of accounts receivables from customers was most effective.

(Are you look for more ways to improve your cash flow? Click here for the free complete checklist guide to improve your cash flow!)

CEI and Your Business

The collection effectiveness index is one of the most useful tools a company can use to monitor the business financials. It measures the speed of converting accounts receivables to closed accounts, which then indicates new methods or procedures one can use to retrieve accounts receivables even more. If the CEI percentage decreases, then that’s a key performance indicator that the company needs to put in place in policies or investigate the departments in more detail.

How to Increase a Company’s CEI

Among other ways to reduce accounts receivable, the collection effectiveness index alerts when and how to change the process of retrieving those accounts. By monitoring cash in a company more frequently, financial leaders will notice a pattern and are more inclined to make a change quicker. Changing your policy from checking 3 times a year to 6 or 8 times a year, and the results that come from it, will show a substantial difference in a company.

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Collection Effectiveness Index

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Operating Cycle Definition

Operating Cycle Definition

The Operating cycle definition establishes how many days it takes to turn purchases of inventory into cash receipts from its eventual sale. It is also known as cash operating cycle, cash conversion cycle, or asset conversion cycle. Operating cycle has three components of payable turnover days, Inventory Turnover days and Accounts Receivable Turnover days. These come together to form the complete measurement of operating cycle days. The operating cycle formula and operating cycle analysis stems logically from these.

The payable turnover days are the period of time in which a company keeps track of how quickly they can pay off their financial obligations to suppliers. Inventory turnover is the ratio that indicates how many times a company sells and replaces their inventory over time. Usually, calculate this ratio by dividing the overall sales by the overall inventory. However, you can also calculate the ratio by dividing COGS by the average inventory. Finally, the accounts receivable turnover days is the period of time the company is evaluated on how fast they can receive payments for their sales. In conclusion, the operating cycle is complete when you put together all of these steps.


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Operating Cycle Applications

The operating cycle concept indicates a company’s true liquidity. By tracking the historical record of the operating cycle of a company and comparing it to its peers in the same industry, it gives investors investment quality of a company. A short company operating cycle is preferable. This is because a company realizes its profits quickly. Thus, it allows a company to quickly acquire cash to use for reinvestment. A long business operating cycle means it takes longer time for a company to turn purchases into cash through sales.

In general, the shorter the cycle, the better a company is. Tie up less time capital in the business process. In other words, it is in a business’ best interest to shorten the business cycle over time. Try to shorten each of the three cycle sections by a small amount. The aggregate change that comes from the shortening of these sections can create a significant change in the overall business cycle. Thus, it can consequently lead to a more successful business.

operating cycle definition

See Also:
Operating Cycle Analysis

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What Does A Lender Want To Know?

See Also:
Relationship with Your Lender
Finding the Right Lender
The Dilemma of Financing a Start-up Company
Every Business has a Funding Source, Few have a Lender
Required Rate of Return
Venture Capital

What Does A Lender Want To Know?

I had a conversation with a prospect that needed working capital funding. He asked, “What does a lender want to know?” I hear this from every prospect I meet with. So, I gave my normal answer, “We will need personal and business financial statements, a completed application, detailed information on accounts receivable and inventory, and that is just the beginning.” After leaving the prospect, I realized not only did I not answer his question, but also I have never totally answered that question. I now know, the prospect is really asking me what information the lender is looking for so he can get the money.

When I answered this question in the past, I just gave a list of requirements and never explained why they were important to the lending decision process. This information is telling the company’s story to the lender. To start with, think of the financial statement you provide the lender as a score card. In the lender’s mind the more income you make the higher your score. As an example, the more runs a baseball team scores the more powerful the team is.

Tell Your Lender This

So after you tell the lender the score of your company, what else does a lender want to know? You should tell the lender about your company with the following information:

• How much money do you want to borrow? The lender needs this information to determine the potential to loan you money.

• Why do you want the money and how will it be used? Think of this one as if your child or family member asked to borrow money from you. I believe you would want to know what they were going to do with the money.

• What primary source will generate the funds to repay the loan? Some ways the lender might expect you to repay the loan are; selling a building, producing a product and selling the inventory, or increasing the profits of your business to generate cash flow.

• What is the secondary source of repayment? Amazingly, lenders want to be repaid as you would if you were loaning money. So they consider such things for their repayment as liquidating equipment or injecting additional capital from personal funds.

• How will the loan be secured (collateral)? The lender wants a security interest in whatever you are going to do with the money.

• Who will guarantee the loan? From the lender’s point of view, you must be 100% sure of your ability to repay the loan. And, you must be willing to put your personal assets on the line. Otherwise, they would be risking their job by making a potentially bad loan.

The better you tell your story the better your chances are of getting the money.

If you want more tips on how to improve cash flow, then click here to access our 25 Ways to Improve Cash Flow whitepaper.

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What is Factoring Receivables

See Also:
Another Way To Look At Factoring
Accounting for Factored Receivables
Journal Entries for Factored Receivables
Can Factoring Be Better Than a Bank Loan?
History of Factoring
How Factoring Can Make or Save Money
Factoring is Not for My Company
The What, When, and Where About Factoring

What Is Factoring Receivables?

Factoring receivables is the sale of accounts receivable for working capital purposes. A company will receive an initial advance, usually around 80% of the amount of an invoice when the invoice is purchased by the lender. When they collect the invoice, the lender pays the remaining 20% (less a fee) to the borrower.

There are two types of factoring conditions: 1) Factoring With Recourse and 2) Factoring Without Recourse. The term recourse refers to whether or not the shareholder(s) of the company are personally liable for the factored receivables in case the company’s client(s) don’t payback the invoiced amount. By far most factoring relationships are conditioned upon With Recourse terms. By shifting more of the risk onto the shareholder(s) of the company, the factoring lender is able to then charge lower fees.

Qualifying for Factoring

The first step in receiving factoring financing is to be pre-qualified by a factoring company or a bank’s factoring department. Typically, this will entail an in-person meeting to review why the company is in need of factoring, as well as the provision of a company’s financial statements and supporting schedules (such as receivables and payables aging schedules) to document its operating history. They will also obtain information on the company’s customers.

A proposal for a factoring relationship will be created. This document will outline the proposed terms of the financing, including a facility limit, advance rate, discount fee schedule, repurchase provision, other fees, liens, process for notification of assignment, confirmation of receivables, and reporting requirements.

The proposal will be negotiated between the company and the representative(s) of the lender before being submitted to the loan committee of the lender for approval. Typically for proposed credit facilities of $1 million or more, lenders require a pre-funding audit of the prospective borrower.


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Factoring Operations

In a factoring relationship, all payments collected for accounts receivable are to be sent to the lender, typically to a “lock-box” under their control. Customers are to be notified of this by a Notification of Assignment letter which will also contain the new payment instructions. Invoices sent by the borrower to their customers will be required to contain the new payment instructions as well.

The borrower decides what invoices to factor (“sell”) by notifying the lender, through the use of a document typically known as a “Schedule A” form. This document will list each individual invoice that needs to be factored. It will have details such as the customer name, invoice number, date, amount, and corresponding purchase order or reference number of the customer. The Schedule A is to be accompanied by documentation which substantiates that the goods or services have been provided to the customers. The lender will decide which invoices it will purchase and then will advance funds to the borrower. This advance is based upon an agreed upon advance rate. The rate is typically around 80%.

Discount Fee

Hold the amount not advanced to the borrower in reserve. Then as customers pay the invoices, release the amount held in reserve to the borrower, less a discount fee.

The discount fee is a percentage that a fee schedule determines. The factoring proposal lays out the fee schedule. The fee is a function of the time it takes for the customer to pay the invoice plus a variable component. The variable component is based upon the prime lending rate. The less time it takes to collect, the smaller the fee. Apply the discount fee to the amount of funds advanced to the borrower.

For those invoices not collected within 90 days of the invoice date, a repurchase provision will apply. This requires the borrower to buy back the invoice, along with a late payment fee (around 5%).

Factoring Lender Reports…..What They Give You

Purchases & Advances Report

The lender will provide a Purchases & Advances Report, which identifies the invoices purchased by the lender, along with the advance rate and amount of each invoice advanced to the borrower. This is typically available daily online.

Collections Report

Lenders also provide a Collections Report, which lists all payments received from a borrower’s customers. Remember that the lender will receive and process all payments for a borrower’s receivables. There are two formats for a Collections Report. Format A lists all payments received for a borrower’s receivables and identifies those which apply to non-factored invoices as well as factored invoices. The detail on a Format A report will include the following:

  • Invoice number
  • Invoice amount
  • Date payment received
  • Amount of the payment collected for each invoice

The second format of a Collections Report is Format D. On a Format D report, information about the reserve refund and discount fee paid out of the reserve for a given invoice is also provided.

Reserve Report

The Reserve Report provided by a lender details changes in the borrower’s reserve account. As invoices are paid and processed, the factoring lender will remit the remaining portion of the reserve. This is usually 20% of the leftover invoice, net of fees. Should there be any outstanding invoices that a customer has not paid back within the agreed upon time period, the factoring lender may require the company to buyback that invoice AND still charge a fee. This type of situation is called “with recourse” because the lender can force the company to “buy back” delinquent invoices.

The borrower is usually required to provide monthly financial statements, including A/R and A/P aging schedules, within 30 days of a month’s end.

If you want more ways to add value to your company, then download your free A/R Checklist to see how simple changes in your A/R process can free up a significant amount of cash.

factoring receivables

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Factoring: What, When, and Where

What, When, and Where about Factoring

In order to make a well informed decision on using factoring services, a CFO must understand the factoring product, truly if you do not; your company should not be using it. But to understand the factoring product, examine it from several perspectives. When you know the what, where, and when to factor, you can answer some of those basic questions.

What is Factoring

Factoring is the purchase of qualified Accounts Receivable or invoices by a factoring company from an operating business in order to provide immediate Cash Flow to that business. Most factoring Purchase Lines allow for you to sell your invoices at 80 to 85% of face value up to a 45 day period from the invoice date. Typically, you can age the invoices up to 90 days from the purchase date before you must buy them back from the factoring company.

Some factoring companies collect your invoices for you and some do not. Some banks allow for you, the client, to collect your own invoices, and use their treasury management services as a mail box for the collection of the invoices. Pricing is typically based on the risk of the deal, size of the deal, and the volume of invoices sold each month. Finding the proper factoring company with the best pricing and the ability to create a strong banking relationship is as important as the characteristics of the deal. That is why the banks have been so successful with their product. They offer the best of both worlds: very competitive pricing and the ability to develop a long term banking relationship.

When To Factor

Deciding when to factor may be the easiest decision to make in the factoring equation. Any transitional need in a company can create a factoring situation. High growth is usually the most common in the Texas market, however, lack of capital, high debt leverage, payroll tax problems, or just not being able to meet your payables within their terms are all reasons for using the factoring product. Always, the primary goal is to increase your cash flow and allow you to smooth out the up and down swings which are created by clients that do not care to pay their bills in a timely manner.

The time value of money becomes critical in these situations, and it seems to be the norm that the larger the client, the slower they pay. This is especially true in the staffing industry where payrolls must be met on a weekly or bi-weekly basis. But clients pay in a 45 to 60 day period subsequent to receiving their bill. Whatever the reason, cash flow is the key element in building and growing a strong business, and if this is your hope for the company you represent as a CFO, then factoring your receivables could be the answer.

Where Should You Factor?

Deciding where to factor is probably the hardest decision to make once you have concluded that factoring may be the answer for your company’s needs. There is a variety of independent and bank owned factoring companies to choose from, and they all have their own cash flow programs. Coined phrases for cash flow solutions are the norm, but keep in mind that there are many differences to their services. Commitment fees, exit fees, delinquency fees, and then standard “factoring fees” all contribute to your cost for the service. Many companies prefer bank owned and operated factoring programs because of the banking relationship it creates and generally lower rates due to the bank’s low cost of money. However, some prefer the service you get from the smaller, independent factoring companies. But keep in mind that you generally pay for that service.

Review Legal Document

Regardless of what type of factoring company you pick to purchase your invoices, always review with a keen eye the legal documents, they will tell the story on the cost of the service. Make sure you have a thorough understanding of the rights of the factoring company and the control they have over the cash flow of your company. Many times you can negotiate away the extra fees, but you must ask. These fees can include the exit fee and the delinquency fee.

Involve Legal Counsel

Also, you may want your legal counsel or your CPA to take a look at the agreement to better define the ramifications for issues that naturally occur in your business, but may not be in accordance with how the program works, like having 60 day payment terms to some of your customers. This small, insignificant issue could put you in default of the Purchase and Sale Agreement and result in higher factoring charges to your company. Clearly, having your council review these documents prior to their execution could save you thousands down the road.

Ask for References

Lastly, a real acid test for a factoring company is to ask for references, and find some clients that are no longer with the factoring company, as this could tell you volumes on how they treat their clients, and how well their services work on a day to day basis. Good factoring companies should have no problem allowing you to check them out. Since factoring is largely unregulated, you owe it to your company to do at least this much due diligence. Good luck and may your cash flow freely.

For more tips on how to improve cash flow, click here to access our 25 Ways to Improve Cash Flow whitepaper.

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See Also:
Another Way To Look At Factoring
Accounting for Factored Receivables
Journal Entries for Factored Receivables
Can Factoring Be Better Than a Bank Loan?
Factoring is Not for My Company
History of Factoring
How Factoring Can Make or Save Money
What is Factoring Receivables

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Self-Liquidating Loans

Self-Liquidating Loans

The term “self-liquidating loans” is banker slang. It refers to a loan that is used to generate proceeds that are in turn used to repay the loan. Basically, a borrower takes out a loan used to finance business activities that generate revenue. Then the borrower takes the revenue generated from those business activities and uses it to repay the money that was borrowed to finance the activities.

Self-Liquidating Loan Example

The term can apply to a company that experiences seasonal fluctuations in business. During the busy season when business is booming the company needs to borrow money to finance short-term assets such as inventory and accounts receivable. The company borrows money to buy more materials to take advantage of the increasing demand of the busy season.

Then when business slows down the company will have less of a need for borrowed funds to finance short-term assets like inventory accounts – the need for financing will decline as the need for inventory declines. At this point, the company will have generated profits from the busy season, and will now be able to use those profits to repay the loans it took out to finance operations during the busy season. And this is called a self-liquidating loan.


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self-liquidating loans

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self-liquidating loans

Source:

Higgins, Robert C. “Analysis for Financial Management”, McGraw-Hill Irwin, New York, NY, 2007.

See Also:
Loan Agreement
Collateralized Debt Obligations
When is an interest rate not as important in selecting a loan?
Debt Ratio Analysis
Debt Service Coverage Ratio (DSCR)

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