What savings are realized when accounts receivable are factored rather than pledged?
This question relates to accounts receivable management, the process of collecting amounts due from customers to ensure a firm?s cash flows remain at an optimal level. Oftentimes, a firm will employ alternative approaches to accelerate cash flows relating to its receivables. Two common methods are factoring and pledging.
Answer and Explanation:
Factoring a receivable balance entails selling the asset to another firm, typically a collections firm, at a discount. The buying firm will pay the seller cash upfront for the asset and assume all collection related responsibilities point forward, keeping what it collects.
Pledging a receivable balance involves procuring a loan and using the asset as collateral. In such an arrangement, the lender will typically assess the firm's book of receivables and extend a loan for some portion of the balances deemed collectible (typically 75-85% of the value).
When pledging receivables, the lender plays no role in the collection process. As a result, the cost of collecting the receivables will continue to be incurred by the borrower. As a result, factoring can be viewed as offering some degree of savings versus pledging. That said, the cost of collections is undoubtedly incorporated into the agreed upon factor discount. For this reason, the claim that pledging offers a savings over factoring is a stretch.
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from Accounting 101: Financial AccountingChapter 7 / Lesson 1