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Vol. 29, Issue 1 | 39
BENEFITS AND COSTS OF FINANCING ACCOUNTS
RECEIVABLE PORTFOLIOS IN THE HEALTHCARE INDUSTRY
Roger Lee Mendoza
1
California State University-Los Angeles
SUMMARY: Accounts receivable (A/R) financing refers to cash conversion of an organization’s
eligible portfolio of outstanding invoices for its operating capital requirements. This study inves-
tigates why A/R financing is critically important in meeting the short-term cash demand of
healthcare organizations, in particular. It distinguishes between two basic conversion methods,
namely, invoice pledging for loan collateral, and asset sale through invoice factoring, and their
respective benefits and drawbacks. In doing so, the study uncovers a quintessential paradox in
healthcare finance: Insurers primarily drive healthcare organizations to seek A/R financing, yet
they are often the main reason why many creditors opt to stay out of, or impose greater restrictions
on, A/R financing, including how A/R financing agreements are structured. Nonetheless, the study
asserts that healthcare organizations may consider A/R financing not just to override cash flow
deficiency, but to grow and invest in a healthcare business, provided the anticipated financial
outcome is a net gain that outweighs the costs of giving away a portion of organizational cash
flow.
Keywords: Accounts Receivable (A/R), Cash Flow, Factoring, Pledging, Revenue Cycle, Risk
Management, Transaction Costs
JEL Classification Codes: G20; I10; I13; M41
Introduction
There is a dearth of literature on accounts receivable (A/R) financing, which most
healthcare organizations are unfamiliar to begin with. We investigate why A/R financing is criti-
cally important in generating cash flow for healthcare organizations. In doing so, we distinguish
between two basic methods of receivable conversion and their respective benefits and drawbacks.
We also analyze the efficient uses of A/R for revenue cycle management, financial risk manage-
ment, and consequently, organizational growth. Theoretical and practical implications are dis-
cussed by way of conclusion.
1
Department of Management, College of Business and Economics, California State Univer-
sity-Los Angeles, 5151 State University Drive, Los Angeles, CA 90032, USA. Email address:
rmendoza@calstatela.edu
The author acknowledges, with thanks, the helpful comments and suggestions of this journal’s
anonymous peer reviewers, and Professor Barry Hunt of California State University-Los Angeles.
This study was funded by a summer research grant from the College of Business and Economics of
California State University-Los Angeles. As with any work of this nature, the usual caveat applies.
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Revenue Cycle Imperatives
Cash flow requirements
A/R in the healthcare industry refer to payments owed — mostly by insuring third-parties
— to a healthcare provider for treatments and services rendered to patients. The payer’s debt
becomes a receivable after an invoice is sent by the provider to the payer (Needles, Powers &
Crosson, 2011).
A/R are critical to revenue cycle and financial risk management of healthcare
organizations, considering that healthcare in the United States is predominantly paid for by insur-
ance, whether private/commercial, non-profit, or government. In 2018, for instance, 87 percent
of hospital care and 82 percent of physician and clinical services were billed to private insurance,
Medicare, Medicaid, and other insurers, such as Worker’s Compensation and auto insurance
(CHCF, 2020).
The revenue cycle is a multi-disciplinary effort to reduce the collection period
for A/R based on sound credit-and-collection policies and financial risk management.
Most providers face short-term cash needs for various reasons, besides price increases,
operational expansion, and current liabilities. Among these is the capital-intensive nature of
healthcare. Replenishing working capital is an ongoing need that requires massive infusion of
cash, particularly in updating or purchasing new equipment and other inventory and conducting
capital-intensive research and development to keep up with medical innovation. Legal and regu-
latory compliance is another important area that is highly dependent on cash flow in light of its
relatively heavy transaction costs (e.g., arising from constantly evolving and changing federal reg-
ulations). Health information technology can be equally burdensome to providers. Besides the
cost of purchasing and installing an electronic medical record system, which ranges from $15,000
to $70,000 per provider (ONC, 2021), it requires trained staff and regulation-compliant infor-
mation systems (Mendoza, 2017). The predominant role of insurance in financing healthcare am-
plifies short-term cash flow requirements, especially because insurers do not typically reimburse
for actual cost of care. Rather, they reimburse based on charges minus discounts, price caps,
predetermined or prospective reimbursement rates (e.g., Medicare’s diagnosis-related groups or
DRGs), and negotiated concessions based on patient volume.
Because financial institutions are
generally reluctant to deal with insurers owing to the financial risk they represent in these in-
stances, most healthcare organizations do not qualify for conventional short-term loans and unse-
cured line of credit (Mendoza, 2020).
Writing off some outstanding accounts as bad debt does not generally work in the organi-
zation’s interest, except in instances where the amount involved is negligible or less than collection
cost (Nowicki, 2018). Otherwise, it means forfeiting considerable revenue. It also sends the wrong
signal to payers, especially in iterated transactions with the provider.
Third-party reimbursements
Healthcare organizations are constantly under pressure from their senior management and
governing boards to address cash flow problems arising from delayed or inadequate reimburse-
ment by health insurers. The vast majority of provider insurance claims, with an average payment
due date of 30 days, are actually paid between 60 to 120 days. Medicare and Medicaid take 60
days or slightly more, while commercial insurers take 90 to 120 days on average,
which means
payment for healthcare comes long after a patient is treated (Factor Finders, 2020a). Third-party
reimbursements also tend to be much lower than cost of care, presumably in exchange for patient
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volume offered by the insurer (Morrisey, 2020). In-network provider classification is another
source of bargaining power on the part of the insurer (Mendoza, 2021).
The long time it takes to collect from third-parties and the low reimbursement ratios rela-
tive to cost of care are very challenging to most healthcare organizations of any size (Hollis, 2017).
Against this backdrop, some organizations that are familiar with receivable financing might seek
agreements with certain financial institutions to generate needed cash flow. There are essentially
two avenues for conversion: pledging and factoring their eligible A/R.
Pledging for Loan Collateral
Purpose and advantages
Pledging is more commonly available to healthcare organizations than factoring, if only
because the loan is secured and the creditor does not have to go after third-parties, particularly
insurers. In pledging, the organization puts up a portfolio of qualified A/R as proof of financial
solvency and collateral in backing a loan, which is usually a line of asset-based credit.
In pledging, new receivables become immediately available as security. Another advantage
is that the organization retains full title to the receivables, which means it still owns and collects
them. And because full title is preserved in favor of the borrowing organization, it is not necessary
to notify any payer of the legal security interest that a lender gains in the accounts, unlike in the
case of factoring (Needles et al., 2011).
From an accounting standpoint, pledging is considered a form of off-balance sheet financ-
ing. This means that the organization does not record A/R along with the corresponding debt. It
is sufficient that disclosure is made through a note to the Balance Sheet. This frees up capital,
eases creditor concerns, and reduces regulatory bottlenecks (Codjia, 2017).
Process
Pledging typically proceeds from five or six steps, as summarily laid down below:
1. After pledging as a cash conversion strategy is approved by the organizational leader-
ship, the Finance team assembles a portfolio of A/R to commit.
Note: Medicare and Medicaid A/R may be legally offered as collateral. Given federal
anti-assignment provisions, the risk of collateralizing these government accounts may
be mitigated in certain ways. One of these is to set up a “double lockbox” arrangement
with a “daily sweep” feature. Under this lockbox arrangement, the first lockbox is
placed in the borrowing provider’s name and solely dedicated to receiving Medicare
and Medicaid A/R. The provider directs the disposition and retrieval of funds from
this lockbox. The second lockbox is in the name of the lender, for the benefit of the
provider, and receives all non-Medicare/Medicaid receivables. Thus, the lender should
ensure that the first lockbox is “swept” daily to move all Medicare and Medicaid funds
to the second lockbox (Rose, 2016).
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2. The committed A/R portfolio is reviewed with potential lenders, who heed the quality
of receivables based on payer profile and creditworthiness and the average collection
period and other relevant ratios.
3. The lender will typically !demand a haircut” (delimit financial/credit risk) based on one
of two options:
a) The loan-to-value (LTV) ratio compares the size of the proposed loan to the pledged
value of eligible A/R. The loan amount is presumably much smaller than the
pledged A/R portfolio. The lender retains leverage under the LTV approach by
advancing only a portion of pledged accounts (Hayes, 2020). Low LTV ratios
(usually ≤ 80 percent for healthcare organizations) indicate credit risk managea-
bility.
Hospital ABC seeks a $1.5 million loan. It pledges a $2 million A/R portfolio
approved by the lender. Lender grants the loan and offers favorable terms,
including its prime rate (e.g., 3.25 percent prime rate + 5 percent for Hospital
ABC’s creditworthiness). Loan application and other transaction fees apply.
loan amount
LTV = ______________
eligible A/R
$1,500,000
= ______________
2,000,000
= 0.75
b) A borrowing base (BB) formula, which is the other pledging option, represents a
predetermined percentage distribution of A/R that changes or declines with the ag-
ing of the receivables. The proportion of age-eligible A/R has to be acceptable to
the lender. It is considered safer for risk-mitigation on the part of the lender, as it
identifies (older) receivables that are least likely to be collected (Bragg, 2019), es-
pecially from insurers
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4. The terms of contract are drawn. The lender gains a lien on the receivables, so that it
may collect on them if the borrower defaults, and then charge against the reserve ac-
cordingly.
5. The approved loan is released by the lender to the organization pursuant to the borrowing
terms and provisions.
6. For the BB option, healthcare organizations will also need to complete and submit to the
lender a BB certificate during each reporting period. The certificate itemizes the out-
standing invoices at period end into the age brackets prescribed/approved by the lender
and (re)calculates step 3-b above for the maximum allowable loan. This allows the
lender to monitor the amount of collateral available, and adjust issued debt over time
(Bragg, 2019).
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Disadvantages
There are certain drawbacks to pledging.
First, A/R are committed to the lender for a given period of time. The secured lender gains
control of the deposit account by virtue of the depository agreeing to take instructions from the
lender without having to obtain the borrower’s (i.e., the healthcare provider’s) consent.
Second, using receivables to secure a loan is usually based on an interest rate that is higher
than most other sources of short-term financing or conventional loans (Nowicki, 2018). Pledging
rates range from 2 percent above prime and up. In addition, a service fee based on the face value
of the receivables is charged. Higher LTV ratios (>0.80) in step 3-a, if allowed by the lender, will
likely command higher interest rates.
Third, pledging often requires repayment by the borrower in the short-run. Healthcare
organizations are often time-constrained and resource-challenged (e.g., due to various working
capital needs), and yet pledging tends to have shorter terms compared to long-term loans.
Despite lender risk mitigation schemes that it can devised for the pledging options, banks
will usually not lend against insurer A/R owing to their track record of
late or partial reimburse-
ments to providers, in addition to the transaction costs of insurance claims resolution (Wallery,
2004).
Invoice Factoring
Purpose and types
Unlike pledging, factoring is a form of asset sale that discounts receivables upon their pur-
chase by a financial institution, provided these are invoiced to third-party insurers and insurance
carriers (e.g., physician offices, home health care companies, medical transport companies, labs,
etc.). The financial institution purchasing receivable is often called a factor (or medical factor in
the case of the healthcare industry). The cash advanced by the factor can be used by the organiza-
tion for any purpose.
As with other industries, there are two types of medical factoring available to healthcare
organizations. It may be done with recourse or without recourse. The former allows the medical
factor to return any A/R to, and demand payment (e.g., at invoice face value) from the organization,
if the factor cannot recover payment from the insurer or third-party payer within a stipulated time
frame (e.g., 90 days). The latter leaves to the factor the financial risks of debt collection. In
exchange, a higher factoring fee, lower cash advance rate, and other safeguards are applied by the
factor to compensate for financial risks when factoring is contracted without recourse. A non-
recourse validity guarantee is also required of the provider or healthcare organization, enabling the
factor to go after it where fraud relative to the accounts it purchased is suspected or proven.
Process
Factoring typically proceeds from six steps, as summarily laid down below:
1. After factoring as a cash conversion strategy is approved by the organizational leader-
ship, the Finance Department assembles a portfolio of A/R to commit.
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Note: Factoring Medicare and Medicaid receivables is ideally done through the “double
lockbox” previously described in pledging. To the second lockbox these factored re-
ceivables are transferred on a daily basis (Heffner, 2020).
2. A medical factor or factoring firm (which could be more than one) is selected, after which
a contract is drawn up. The transacting parties indicate in the contract whether to factor
with or without recourse. Facility set-up and underwriting fees and a due diligence de-
posit are subsequently paid by the provider or healthcare organization to the factor.
3. The factor estimates the net collectible value (NCV) of all eligible A/R from each third-
party payer based on a predetermined period of time (usually 120 days or less). The NCV
is the portion (percentage) of these A/R that the factor expects to collect from each payer
relative to invoice face value of their pending invoices. Ineligible accounts, consisting of
patient cost-sharing (e.g., copays, co-insurances, etc.), contractual reserves, and aged re-
ceivables, are normally excluded from the calculation
Hospital XYZ invoiced Hollis Insurance $2 million in the fourth quarter
of 2020 . It collected $1 million from these invoices within 90 days:
Average Period Collection
NCV = _______________________
Average Period Invoices
= $1,000,000
______________________
2,000,000
= 0.50
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4. The healthcare organization then cedes the eligible A/R titles per payer to the factor.
It notifies payers to transmit payments to the factor which now takes over the collec-
tion process.
Among the eligible accounts that the medical factor purchased from
Hospital XYZ under a factoring with recourse scheme is invoice #101 to
Hollis Insurance. XYZ is compelled to buy it back at face value ($2,000) if
uncollected by the factor after a maximum period of 90 days. At an NCV
of $1,000, the factor uses an industry-standard, advance rate of 80 percent
and pays XYZ $800. The balance of $200 (20 percent) is set aside as a re-
serve.
• Eligible A/R #1 (face value): $2,000
• NCV@50% of eligible A/R: 1,000
• Factor (advance rate) @80%: 800
• Reserve@20%: 200
5. For invoice payments collected by the medical factor within the initial period (e.g., the
first 30 days of the 90-day maximum), the factor retrieves a portion equal to the amount
it had previously advanced to the provider or healthcare organization. The factor deducts
the factoring fee from the reserve. This service fee is analogous to credit card sales. In
a credit card sale, the retailer pays a percentage fee to a financier in order for the financier
to pay the account and take on the risk of debt collection. Non-collection and erroneous
account fees can also be fully or partially charged against this reserve.
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The factor collects payment ($1,000) on invoice #101 within 30 days
(collection period is extendible to 90 days with corresponding interest rate
increases). Therefore:
• Actual collection from insurer: $1,000
• Recoupment from cash advance: 800
• Factoring fee@2.0% of NCV: 20
• Reserve balance (minus factoring fee): 180
• Released to Hospital XYZ: $ 180
6. The factor releases the reserve balance to the organization. The organization, in effect,
received a total payment from the factor equal to the initial cash advance and the reserve
balance. This completes the provider-factor transaction for a particular A/R.
Hospital XYZ receives $980 net of invoice #101.
If the factor collects less than NCV from Hollis Insurance, the differ-
ence is charged against the reserve of another (paid) XYZ invoice. Con-
versely, if payment collected is greater than NCV (e.g., $1,300), XYZ is
then credited for the overpayment.
Advantages
Certain benefits to factoring resemble pledging: 1) It is available to non-bankable provid-
ers, with no required compensating balances; 2) It offers the flexibility of converting receivables
into instant operating cash for unrestricted (especially working capital) use; and 3) There are no
conversion limits, which gives the provider better control of the revenue cycle.
Unlike a bank loan, factoring firms do not offer a fixed credit line, but as new receivables
are accounted for, the organization gains access to more working capital. And since the organiza-
tion is selling an asset, it does not incur debt in factoring its A/R. That is also to say that even if
the provider is just starting up its business and/or has encountered credit-related difficulties in the
past, it can still be approved for medical factoring without collateral.
This is particularly im-
portant, considering that many banks and other creditors are unwilling to fund healthcare organi-
zations with only outstanding invoices for their back-up asset. Additional pledging restrictions
may, of course, be imposed by creditors if these are insurer invoices. Some banks only focus on
large healthcare organizations with substantial history (Sopranzetti, 1998; Codia, 2017).
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Assuming a healthcare organization is considering a commercial bank for working capital
loans, the table below outlines the main differences between factoring and conventional borrowing:
Aspect Factoring Bank Loan
Principal + interest None Yes
Credit history Not applicable Applicable & analyzed
Assets & liabilities Not applicable Applicable & analyzed
Processing time
Factoring account set up w/in a few
days
Loan approval: 1-2+ months
on average
Required paperwork
Minimal Extensive documentation
Rates
Adjustible as larger eligible $ amounts
are factored
Interest rates locked
Credit line
Unlimited + grows w/ organization &
receivables
Borrowing amount limited or
capped
It should also be noted that factoring avoids most overhead costs to the provider or healthcare
organization, as medical factors typically take over billing and collection. However, there are
some factoring contracts where the provider remains responsible for these operations.
Disadvantages
One disadvantage of medical factoring is organizational expense, in the form of transaction
and other fees that could end up being more than what other sources of short-term financing usually
charge. Secondly, if A/R are sold with recourse (as exemplified by the hypothetical Hospital XYZ
in our preceding illustration), the organization would have ongoing financial risk. Finally, the
sale of A/R may alienate payers if the factor pursues aggressive collection measures or miscom-
munication arises between the medical factor and the payer.
While factors doubtless gain from a calculated profit, several choose not to invest in
healthcare accounts “due to their volatility and ambiguous nature. This holds even more true for
A/R heavy in litigious claims, as these accounts often take longer to settle and factoring is meant
primarily as a short-term financing option” (Wallery, 2004, p. 3).
Unpredictability of insurer re-
imbursements often lead medical factors to subjectively lower their advance rates and increase
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factoring and other fees relative to NCV, which estimates how much the factor will likely collect
at less than invoice face value.
Conclusion
The age-old saying, “cash is king,” says it all. Maintaining a healthy and stable cash flow
is one of the financial challenges that healthcare organizations face daily. Much of this owes to
delayed and less than full reimbursements by third-party payers, notably insurers, whether com-
mercial, non-profit, or government. Contested insurance claims add to these challenges.
Healthcare organizations have immediate cash needs for working capital, and constant cash
flow challenges from business expansion, scientific/technological innovation, and regulatory com-
pliance. Inaccessibility of many business loans and unsecured lines of credit, due largely to the
reimbursement reputation of insurers, create barriers to cash flow. Here lies the quintessential
paradox in healthcare finance: Insurers primarily drive healthcare organizations to seek receivable
financing to address liquidity problems. Yet, insurers are also the main reason why many creditors
elect to stay out of, or impose greater restrictions on, medical receivable financing, especially fac-
toring. But because over 80 percent of their invoices are billed to third-party payers, notably in-
surers, providers remain highly dependent on
them for their revenue base. Providers thus need to
find practical avenues to infuse cash into their operations, as well as financing and investing ac-
tivities.
We distinguished between two methods of cash conversion for the A/R of healthcare or-
ganizations: pledging, which is more commonly available but seldom considered, and factoring,
which has a lesser number of financial institutions offering it, but is more often sought by provid-
ers. By delivering instant cash to meet short-term cash flow needs, these conversion methods can
help sustain longer term efficiencies, especially if part of the cash inflow is invested. Both also
contrast from conventional borrowing as a means of raising revenue and capital. Pledging and
factoring offer key benefits, as providers become saddled with unpaid invoices and collection
problems. They have costs and drawbacks as well.
Besides the practical implications, some theoretical implications can be drawn from financ-
ing A/R portfolios in the healthcare industry. A/R constitute one important type of liquid asset
used to identify and value a healthcare organization’s most liquid assets. The Quick Ratio, in
particular, measures for asset liquidity. After all, the underlying strategic assumption in revenue
cycle and working capital management is that a balance between adequate cash flows for opera-
tions and the productive uses of organizational resources should be kept. This serves to underscore
the critical importance of periodically evaluating the cash-to-cash cycle, i.e, the length of time it
takes for (a healthcare organization’s) income or profit tied up in production and inventory to
generate cash through payments for healthcare treatments and services:
Cash equivalents + Marketable securities + A/R (due 12 months)
Quick Ratio = ______________________________________________________
Current Liabilities
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There is no gainsaying that the effectiveness of working capital can be enhanced if a
healthcare provider or organization can reduce the average time it takes to collect a receivable.
They might generally regard A/R as burdensome to the revenue cycle, since they are not immedi-
ately cash-convertible and require collection efforts (and costs). The highly liquid form of A/R,
on the other hand, translates to theoretical value for external lenders and financiers. Banks, med-
ical factors, and other financial institutions have stepped in to address these challenges, with most
A/R financing agreements typically structured as loans or asset sales to contain the transaction
costs of these A/R to both provider and financial institution. In this sense, lenders and financiers
help boost healthcare organizational growth by facilitating low or lower transaction costs, espe-
cially compliance costs on the part of insurers.
Transaction costs or expenses are incurred when buying or selling a good or service in the
market. Hence, search and information, bargaining and decision-making, and monitoring and en-
forcement costs are incurred by the transacting parties (Coase, 1937; Pessali, 2006). Of particular
importance in A/R conversion are measurement costs (e.g., A/R eligibility and value calculation,
which form part of search and information costs) and enforcement costs (to ensure that neither
party in the A/R financing transaction reneges on their part of the deal). There could also be
substantial negotiation costs (e.g., in discounting and purchasing eligible invoices, setting terms
and provisions of recourse or non-recourse factoring, etc.). Because the theory of transaction
costs essentially treats property rights and contracts as problematic — epitomized in this study by
a track record of delayed or less than full insurer reimbursements — it inevitably leads one to ask
what kind of institutions or firms can minimize the transaction costs of producing, delivering, and
receiving compensation for healthcare treatments and services. This study suggests that often
these processes and transactions are categorized by the kind of contract involved (i.e., between
provider and insurer or cash-converting firm). They are also influenced by how a contract is al-
ternatively or creatively enforced when compliance issues arise (e.g, with the involvement of lend-
ers and financiers). It is well to bear in mind that the higher the frequency of transactions between
contracting parties, the higher the relative administrative and bargaining costs (Williamson, 1979).
Healthcare organizations should nonetheless consider addressing areas
of unnecessary rev-
enue loss, operational processes, and expenditure trends before seeking A/R financing. After all,
these tie up to the revenue cycle. By systematically reviewing and valuing A/R, financial risk
analysis can establish collection rates and predict future returns before an organization compares
between and contracts with lenders, factors, and other financial institutions.
It is from this standpoint that A/R financing could serve a strategic function, and not nec-
essarily as a last resort. If pledging or factoring replenishes cash flow not simply to override
temporary cash deficiency, but to enhance healthcare provision and invest strategically, the next
thing to consider is whether a net gain is likely within a reasonable period of time. If the net gain
from the infusion and uses of additional cash outweighs the costs and expenses of giving away a
portion of cash flow to lenders and factors, A/R financing might be effectively pursued. Once an
organization improves short-term cash flow in a way that maximizes efficiency, growth naturally
follows.
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Vol. 29, Issue 1 | 51
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