October 2009, By David A. Schmidt

Editor's note: The following article was originally published in The Credit Research Foundation's Third Quarter 2009 issue of "Credit and Financial Management Review."

Ever since the day Master Charge (now MasterCard) redefined retailing with the introduction of a universal credit card, the business finance community has been searching for an analogous solution for businesses extending trade credit. The resulting explosion in liquidity derived from the introduction of universal credit cards has been a key economic driver during the past four decades, and it is highly anticipated that the creation of a trade credit solution will likewise free up unprecedented amounts of working capital.

According to the Federal Reserve ("Flow of Funds Accounts of the United States", Table L.223, June 11, 2009), outstanding trade credit in the United States totaled over $3.2 trillion at the end of March, 2009. Just tapping into a fraction of that total will generate hundreds of billions of dollars of additional liquidity.

The Working Capital Tug-of-War
The extension of trade credit facilitates the purchase of goods or services by handling the transaction on account rather than by a simultaneous payment. The agreed upon credit terms then stipulate a future date for settlement of the invoice balance held on account. Until that time, the transaction is reflected as an accounts payable on the buyer's books and an accounts receivable on the seller's ledger.

Even though credit terms are a component of the price offered by the seller, the extension of trade credit is essentially a free loan to the buyer. As a result, it is to the advantage of buyers to extend this free loan as long as possible so they can maximize available working capital. Sellers, in contrast, want to be paid on time, and often offer early payment discounts to accelerate cash flow. This ongoing working capital tug-of-war ultimately restricts growth by extending the Cash Conversion Cycle.

Receivables represent only one component of the Cash Conversion Cycle, which measures the efficiency with which a company manages its working capital. Very simply, the Cash Conversion Cycle is the number of days that transpire between the purchase of production materials by the seller and the date when the seller is finally paid for the goods or services delivered.

Cash Conversion Cycle: CCC = DSO + DSI -- DPO

DSO = (Account Receivable/Total Credit Sales) X 365

DSI = (Inventory/Cost of Goods Sold) X 365

DPO = (Accounts Payable/Cost of Goods Sold) X 365

The longer it takes a business to convert inventory to cash, the lower the business return on equity. As any credit executive will attest, many firms shorten the Cash Conversion Cycle by delaying payment on their payables. Of course that causes a problem on the flip side where having working capital tied up in accounts receivable limits business performance.

Figure 1: Slow Cash Conversion Diminishes Return on Equity (ROE)

Source: The Receivables Exchange

As figure 1 illustrates, the longer an enterprise's Cash Conversion Cycle, the lower its Return on Equity. Holding accounts receivables creates an opportunity cost that can be measured by the lost ROE. To illustrate this loss, consider the following scenario:

Assuming a company can earn 18% on its invested capital and DSO = 44 days

ROE = $100.00 X 1.18(44/365) = $102.02

The opportunity cost is therefore 2.02%

In this case, for every $100 in AR, the company forfeits $2.02 in potential earnings. To put that in perspective, given this illustration, every $1 million tied up in AR translates into over $167,000 in opportunity costs over the course of a year. And that does not even take into account the declining value of receivables as they age. By increasing cash flow and thereby reducing DSO, opportunity costs are reduced as funds are reinvested in the enterprise. One way to do that is to offer an early payment discount, which is easily justified by the opportunity cost in this example.

Another alternative involves selling or financing accounts receivable. Exchanging AR for funding provides a company with excess cash that can immediately be invested in operations. To summarize, the benefits of monetizing receivables in this manner will be:

• Shorter Cash Conversion Cycle
• Lower DSO
• Reinvestment of the freed up Working Capital

A mechanism for trading receivables therefore has the potential to become a catalyst for economic growth by increasing business spending.

The Attraction of Trade Credit as an Investment
On a fundamental level, Wall Street seeks to maximize returns for any given level of risk. Risk is measured by the historical volatility of the assets in question, and by way of comparison to the risk associated with other asset groups. In addition, investors diversify their assets in an effort to avoid concentration risk, which is very simply the risk of holding all your eggs in one basket. To reduce risk through diversification, investors look for assets whose returns over time do not correlate with the historical returns of the assets already owned. Very simply, non-correlated assets within a portfolio reduce risk. Holding a variety of investments will, on average and over time, yield higher returns with lower risk than a single investment or a group of highly correlated investments.

Figure 2: Asset Based Lending (ABL) and the S&P 500 Compared for Return and Volatility (Beta)

Accounts receivable have historically provided very stable returns with minimal volatility. Furthermore, the return profile of AR is uncorrelated to the general market as illustrated in Figure 2. In this chart, Hedgefund.net's Asset Based Lending Index is used a proxy for the returns from AR. While the annualized returns for the ABL Index and the S&P 500 are similar, there is no comparison in respect to volatility, the lack of which for AR being clearly illustrated by the consistency of the ABL line plot.

To top things off, investing in AR at this time provides a higher rate of return than similar investments in short term government or corporate bonds. As a consequence, the investment community is favorably inclined toward investments derived from AR. In addition, tight credit markets have had a deleterious effect on asset based lending and factoring (witness CIT) forcing many small and medium size business to explore alternatives.

Opportunities for Monetizing AR
In the past few years, several different types of financing solutions have been introduced into the market place. Most have evolved from financial institutions, while the remainders have been introduced by technology firms. These solutions can be classified under three groupings: bank-centric, fixed finance and exchange traded.

With bank-centric solutions, the financial institution acts as the middle-man in the cash settlement process. For some time now, banks have been providing settlement solutions for AP departments, including positive pay, which involves the transfer of AP data to the bank, who then uses that data to clear only authorized checks. As banks have expanded their remittance processing solutions, they have also begun collecting AR data from clients. Visibility into a client's AR enables banks to offer financing on specific receivables.

Even more compelling from the banks perspective are those occasions when they have visibility of both the AP and AR side of the transaction. Then they can offer flexible financing terms on both sides of the transaction, hence increasing the bank's effective rate of return. This also serves the growing interest in AP departments around dynamic discounting, which involves taking discounts on a sliding scale dependent on the date of payment rather than for a fixed amount on a date certain. JPMorganChase and US Bank are two of the banks offering AR financing solutions along these lines.

Fixed finance solutions, in comparison, interject fixed terms into the transaction. A good example is provided by PromptPayment, LLC, who offers sellers next day payment less a fixed discount upon invoice approval by the buyer and then extended settlement to the buyer (e.g. a 2 percent discount to the seller and 60 day terms to the buyer). As with the bank-centric solution, the seller can choose which individual invoices to finance within parameters.

In contrast, an exchange traded solution offers market rates by bringing many sellers and debt buyers to the same platform. A high degree of transparency facilitates the bidding process within this open marketplace and thereby insures market efficiency. In the past year, two exchange traded solutions have been successfully launched: SecondMarket, which provides a solution for illiquid assets including bankruptcy claims, and the Receivables Exchange, which is focused on primary trade credit, and which this article will now examine more closely

Advantages of the Exchange Traded Receivables Model
Auctions on the Receivables Exchange, launched last November and now trading up to $1 million daily, are not made for the entire invoice, but much like factoring or an ABL line are for a percentage of the total (e.g. 80 or 90 percent). The seller, however, retains responsibility for collecting the invoice: their customer is not notified of the AR sale. Customers whose invoices are being traded are asked to remit to a lockbox controlled by the exchange, but payment is still made in the name of the seller (if invoices are short paid, it will almost always be less than the hold back, and so does not affect the financing and remains throughout the responsibility of the seller) Auctions are initiated by the seller in much the same way as parameters are set on eBay: both minimal bid requirements and parameters for an immediate sale can be set. Throughout the auction the receivables sellers retain total control over:

• When to auction invoices
• Which invoices to auction
• When the auction closes
• Minimum advance amount
• Maximum discount fee

When a bid has been accepted, the next day the exchange pays the seller the agreed upon advance rate less a small transaction fee (typically 30 to 70 basis points). Simultaneously, the exchange is collecting the advance from the financing source. Upon payment of the invoice, the financing source is paid back for their advance plus the discount and the seller paid for the balance (10-20 percent) less the discount. Discount rates are quoted on a 30-day basis but are then converted to a daily rate that is used to determine the actual discount amount. So if the invoice is paid early, the Seller has a lower cost of capital and if paid late, the discount amount increases proportionately. If a customer does not pay, the receivables seller will be required to return the advance plus finance charges as would be the case in a Factoring arrangement.

The Receivables Exchange model is indeed similar to traditional Factoring, but with a number of important advantages (see Figure 3) primary of which is measurably lower finance rates. An online marketplace is also more efficient, both in terms of the pricing mechanism as well as the electronic transfer of transactional data and timely electronic funds settlement. In the final analysis, an open marketplace facilitating exchange traded receivables provides trade credit grantors with an extremely flexible tool for converting trade credit to an investable asset.

Figure 3: The Advantage of Exchange Traded Receivables Over Traditional AR Financing

The Advantage of Exchange Traded Receivables
... over traditional A/R financing
	Exchange Traded AR	Traditional AR Finance
Notification	Anonymous with Selective Notification Option	Notification required, buyer disclosed to the debtor
Verification	Anonymous	Verification required, buyer disclosed to the debtor
Cost of Capital	Competitive bidding decreases cost	Higher costs due to captive relationship
Fee structure	100% transparency	Lack of transparency and layers of fees can add to cost of funds
Covenants	No restrictive covenants	Numerous restrictive covenants
Personal Guarantees	None	Required
Asset lien	Single receivable lien	All asset lien
Efficiency	100% Straight Through Processing, 1-10 days to fund	All transactions are unique and customized; 15--30 days to fund
Collection Issues	Seller controls the entire collection process so never loses visibility	Disputed items are referred back to the receivables seller