What Are Pledging Receivables? And How Can They Help You Raise Working Capital

Introduction

Sometimes, businesses run short of money, and they need extra cash to keep everything running smoothly. They often get this extra money through short-term loans.

But here’s the thing: Small and medium-sized businesses (SMBs) often have a hard time getting loans from banks because banks think they might not pay the money back.

So, what do these SMBs do? They use something called accounts receivable and inventory financing to raise working capital for daily operations.

Utilizing accounts receivable(AR), or customers’ credit accounts, to obtain finances for your business is a method of meeting working capital needs. By pledging the receivables, businesses gain capital for themselves.

Businesses are frequently offered accounts receivable funding by commercial finance organizations in place of their account receivables as collateral—it’s a flexible financing option and it is designed to provide financial bridging to address cash flow needs. 

The more you understand how pledging accounts receivable work, the better you will be able to leverage them to meet your financing needs.

What Are Pledging Receivables? 

Pledge receivables are the accounts receivables that you submit as collateral to the lender against a pre-decided loan(or capital funds). When you pledge or assign the AR, you are effectively using them as security to receive cash.

Although the receivables are held as collateral by the lender, you, as the business owner, are still responsible for collecting debts from your credit clients. When accounts receivable is handled in this way, the lender usually limits the loan amount to one of the following:

1. 70% to 80% of the entire amount of outstanding accounts receivables; or
2. A fraction of accounts receivables based on the age of the receivables.

The second option above is safer from the lender’s perspective and is more common as it allows for accurate identification of receivables that are less likely to be collected.

Typically, the lender will only accept receivables that are not past the due date. Accounts that are past due do not make suitable collaterals.

Also, if a customer is given credit terms that the lender believes are excessively long, the lender may refuse to accept those receivables as collateral. After evaluating a company’s receivables for overdue accounts, the lender decides how much of the receivables they will accept.

Example of Pledging Receivables

Let’s say Company A borrows $80,000 on December 31, 2021, and agrees to repay $81,600 on April 1, 2022. It pledges $100,000 in trade receivables as collateral for the loan. The company would make the following three journal entries:

31/12/2021 Cash	$80,000
Notes Payable		$80,000
31/03/2022 Interest Expense	$1,600
Notes Payable		$1,600
01/04/2022 Notes Payable	$81,600
Cash		$81,600

Note: The last two entries can be combined, but they are shown separately here for clarity. The only financial statement disclosures for pledged receivables typically appear as notes or parenthetical comments.

How Do You Pledge Receivables?

To pledge receivables, first, the lender looks at the money your customers owe you and checks for any late payments or how long they have to pay. They decide how much they’re willing to lend based on this.

Then, they adjust the amount to cover any possible issues, like returns or allowances. After that, they decide the percentage of the money they’re willing to give you as a loan.

If your business can’t repay the loan or defaults on the AR financing loan, the lender will take the money your customers owe you and collect it themselves.

You don’t need to make special notes in your financial records for pledged receivables. However, the lender still has to approve your AR before making the loan.

How Pledging Receivables Can Help Raise Working Capital

Pledging receivables can help raise working capital by allowing a business to use its outstanding invoices as collateral for a loan.

As discussed above lenders provide funds based on the value of these receivables, providing immediate cash flow that can be used for operational expenses, investments, or other financial needs.

This process improves liquidity and ensures the business can meet its short-term financial requirements, even when customers have not yet paid their invoices.

Final Thoughts

It’s well-known that many small businesses encounter cash flow challenges, but did you know that the leading cause of new business failures is a lack of cash?

In fact, 38 percent of small businesses fail because they either run out of cash or struggle to secure additional financial support.

Pledging receivables can offer a financial lifeline to businesses, providing a financial bridge to address the cash flow needs of these businesses.

So, understanding what they are and how to leverage them to meet your financing needs is crucial. Though they may not suffice for larger funding needs.

FAQs

1). What is the difference between pledging receivables and assigning receivables?

When a business pledges its accounts receivable, it does so as a form of loan collateral. When a business assigns its accounts receivable to a financial institution, it enters into a lending agreement with the bank to receive payment on specific customer accounts.

2). Is pledging and factoring receivables exactly the same process?

In pledging receivables the business promises its account receivables as collateral and gets into a pledging agreement with the lender. The company retains title to and is responsible for collecting accounts receivable, not the lender whereas, in factoring receivables, businesses opt to sell or assign its account receivable (or a specific invoice) to a factoring company in exchange for cash at a discount to its face value. The factor is then responsible for collecting the receivables.

3). Why does a company pledge its receivables?

Pledging receivables is a common practice in the business world, particularly for those seeking additional financing or working capital. By pledging their receivables, businesses can leverage their outstanding invoices to secure a loan and meet their financing needs. 

4). What are the advantages of pledging accounts receivable?

One of the most significant advantages of pledging receivables is the immediate injection of cash into the business. Rather than waiting for customers to make payments, the company can obtain funds upfront by using its outstanding invoices as collateral.

5). What are the journal entries for pledging accounts receivable?

Well, no special journal entries are required for pledging receivables. However, it is crucial to recognize that the lender’s approval must be obtained before the loan is granted, as they have the final say in relinquishing your accounts receivable.