Introduction to Finance

Pledging Accounts Receivable 
Rather than wait until its customers pay on each 
of their accounts, a fi rm can pledge its accounts and get a loan. By so doing, the fi rm obtains 
funds sooner, albeit at a cost. The word “accounts” in accounts receivable is plural. When a 
fi rm pledges its accounts receivable, each customer’s account is reviewed to see if it is cred-
itworthy to become security, or collateral, for a loan. The lender, usually a bank or fi nance 
company, gives close attention to the borrower’s collection experience on its receivables and 
to certain characteristics of its accounts receivable. 
The bank may spot-check the receivables of the fi rm and may, in some cases, analyze each 
account to determine how quickly the fi rm’s customers make payments. The bank must know 
something about these customers; it will probably check on their credit ratings from a source 
secured lending or asset-based 
lending 
collateral or security 
backing the loan that can be claimed 
or sold by the lender if the borrower 
defaults
pledge 
obtain a short-term loan 
by using accounts receivable as 
collateral
factor 
a fi rm that engages in 
accounts receivable fi nancing by 
purchasing accounts and assuming 
all credit risks

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16.5 Additional Varieties of Short-Term Financing
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such as Dun & Bradstreet (D&B). Their ability to pay their debts will strongly infl uence how 
well the business applying for the loan can collect payment.
In addition, the bank studies the type and quality of goods sold. If the merchandise is 
inferior, the customers may have objections and have slower payment of bills or sales returns. 
Accounts receivable are of little value as security for a loan if large quantities of merchandise 
are returned and the amount of accounts receivable is reduced accordingly. 
A loan based on accounts receivable is usually no more than 80 percent of the gross 
receivables. This amount should be reduced by any discounts allowed to customers for quick 
payment, and by the normal percentage of merchandise returns. If the bank believes many of 
the loan applicant’s customers are unsuitable risks or if adequate credit ratings are unavailable, 
it will lend a lower percentage of the face value of the receivables. Additionally, if a single cus-
tomer is a large proportion of the fi rm’s credit sales, the percentage lent against that account 
may be less than usual; this protects the bank in case a large customer of the fi rm experiences 
fi nancial diffi
culties, which may create subsequent cash fl ow problems for the supplying fi rm.
Pledging accounts receivable is not a simple process. The fi rm’s accounts receivable are 
reviewed by the bank to determine their level and if they are acceptable to form the basis for 
a loan. At the time the loan is made, individual accounts on the ledger of the business are 
designated clearly as having been pledged for the bank loan. Only those accounts suitable 
for collateral purposes for the bank are designated. When these accounts are paid in full or 
become unsatisfactory, they are replaced by other accounts. 
Pledging accounts receivable involves sending invoices and funds (electronically or by 
paper) back and forth among the fi rm, its customers, and the bank off ering the loan. For 
example, the bank receives copies of all shipping invoices to show the goods have been shipped 
and the account receivable is valid. Thus, invoice material is transferred from fi rm to customer 
and from fi rm to bank. Similarly, several transfers of funds exist. First, the bank lends funds to 
the fi rm. Second, the fi rm’s customers make payments on the pledged receivables. Third, the 
fi rm sends such payments to the bank to repay the loan.
ETHICAL
It is usually more expensive to pledge receivables than to borrow funds from a 
bank. Under a pledged receivables arrangement, the fi rm pays interest on the loan (namely, 
the funds advanced to it) and a separate fee to cover the extra work needed for the loan. The 
bank must periodically check or audit the books of the business to see that it is living up to the 
terms of the agreement and sending customer payments to it in a timely basis. As customers 
pay their bills on the pledged account assigned for the loan, the proceeds must be turned over 
to the bank. The bank reserves the right to audit the business’s books and to have an outside 
accounting fi rm examine the books periodically. 
In what is referred to as “supply chain fi nancing,” some banks in the United States are 
helping the cash fl ow of smaller businesses by off ering pledging (or factoring, discussed in 
the next section) services to small businesses that sell goods to larger businesses—but charges 
interest at a rate based on the larger fi rm’s credit rating.
15
With supply chain fi nancing, the 
bank, in order to keep the large fi rm’s supply of inventory at appropriate levels, will off er a 
small business that supplies goods to a large business the chance to pledge its receivables from 
its customers. Due to the consistent relation with the larger fi rm, the bank off ers the small 
business supplier a lending interest rate commensurate with the large fi rm’s credit rating. In 
this way, the small business has predictable cash fl ow and the large business has a more stable 
supply relationship—as now there is less of a chance of the small business going bankrupt if 
its customers are slow to pay their bills. And the bank that fi nances the small fi rm’s receiv-
ables has a new client and new sources of income from the interest it receives from the fi nan-
cing it provides—all parties “win” with supply chain fi nancing.