What is commingling risk?
It is a catchall term for the risk that is involved when the buyer pay but the money doesn’t reach the investor. The cash that the buyer has paid either gets lost or gets absorbed in transit. It is a major issue in trade receivable finance.
Commingling is also defined as an act of failing to differentiate between your business and personal expenses. As a business owner, especially of it is a sole proprietorship, you won’t separate between these two expenses. You may use money in your business account for your personal expenses.
Examples of commingling risk:
Commingling can occur in these ways
- When the same bank account is used for your business and personal expenses.
- When you use business funds to buy personal assets.
- Even though the buyer pays the supplier, still the supplier does not hand over the money
- When the buyer pays the cash and transfers it into the right bank account but still, there is a failure to identify the payment. In this case, the payment cannot be allocated to the trade receivable.
- Sometimes the cash is paid but it is commingled (it means combined with) other cash balances on the bank. In this case some other creditor steps in and takes the cash for himself.
In receivable financing, the last risk is the most prominent and usually occurring risk. This usually happens when the arranger or originator of financing goes out of money leaving behind numerous creditors. In the ensuing fight over whatever assets are left of the insolvent part, other creditors manage to get a hand over that cash.
Why is commingling bad?
In trade receivable financing, we generally say 50% risk is that the buyer does not pay and the other 50% risk is that even after the payment has been made by the buyer, it doesn’t reach the investor.
Commingling is bad because:
- It makes keeping track of your business performance difficult. If you use the same business account for personal expenses, it becomes difficult to identify the entries to consider while calculating profit or loss for your business. It is a painstaking task to manually check each and every entry and leads to mistakes.
- Problems may arise when you try to claim tax deductions. Business is allowed certain tax deductions for their business expenses. But when your personal and business expenses are commingled, it becomes difficult to claim tax deductions.
- Trade receivables are turned into cash quickly. So there is a risk of big cash balances arising quickly, and the buyer keeps on paying even after some problem has arisen.
- While the investors take ownership or security over a receivable, but when the buyer pays the receivable, the secured assets gets disappeared and gets converted into cash that to in some bank account somewhere. At this point, unless something is done, the investor has become unsecured. The receivable asset has been replaced by cash asset but the investor has no attachment to that cash now.
This is why commingling risk is considered so bad.
How it can be avoided?
Commingling risk can be pre-empted by taking some measures like:
- Open a separate business bank account. This bank account should only be used for expenses like buying inventory, paying employees, purchasing fixed assets, etc.
- Asking buyers to make payments directly to investors and not to the original suppliers.
- An assignment notice can be sent to the buyers stating that the receivable belongs to the investor. This means that the obligation can’t be met by paying the supplier anymore. You will have to directly pay the investor.
- The bank account should be set in such a way that they are under the direct control of the investor and the buyers should be directed to pay for them.
Is it really necessary?
Taking these preventive measures are necessary because if not take, then the risk that the investors take when they finance will get diluted by the credit risk of the involved parties in the trade. These issues can become the material points that lead to the failure of the structure of:
- The supplier
- The servicer of the portfolio who is responsible for managing the receivables and collecting the cash
- And the bank that provides the bank accounts