Accounts Receivable Financing
Accounts receivable financing is similar to a traditional business loan, except there are no monthly payments. The business' invoices are used as collateral, creating an asset-based loan. This kind of loan frees up cash flow that is locked away in outstanding invoices. Accounts receivable financing also has faster approval and funding times than a traditional loan.
The structure of accounts receivable financing varies across lenders. Some lenders structure financing like a loan. In this setup, customers pay the business as usual, and the business owner pays the lender. In another scenario, customers pay the lender directly. In both cases, the business is advanced the value of outstanding invoices minus a fee, usually within a few days after approval.
Depending on the lender, they can integrate with accounting software such as Quickbooks or Xero. Such integration offloads recording payments and reconciling invoices. These services may cost extra.
Accounts receivable financing allows a business to be selective about which invoices it wants to use. This offers some flexibility to the business. If a business owner knows 60% of outstanding invoices are held by reliable customers, it may not want to finance those invoices. For the other 40% of invoices that generally take longer to pay and are held by some customers who can be more difficult to collect payment from, it can make more sense to pay extra for a collections service and the advancement of cash.
Accounts receivable financing comes in two options - recourse and non-recourse.
With recourse financing, the business owner must pay back any uncollected invoices. Most lenders use recourse. This model removes risk for lenders and transfers it to the applicant. Lenders have the right to come after the business owner for any uncollected debt. It's also easier for lenders to pursue one entity rather than multiple (i.e., the business owner's customers). One advantage for the business owner is that fees can be lower when using a recourse lender.
In non-recourse financing, the lender assumes all the risk from any uncollected payments. Because of this high risk, lenders charge more than recourse financing. They also apply more scrutiny to a business' customers to ensure they can pay. An advantage for business owners is that they don't have to worry about uncollected debt affecting them.
What Are The Qualifications?
Finance companies will look at the age, quality, and amount of invoices to be financed. Depending on the lender, they may also factor in the business' revenue, ratios, and type of business.
What Are The Cost?
Fees are charged each week funds remain outstanding. Rather than a flat fee, lenders charge the fee as an interest rate, which accrues weekly. Common recourse fees are between 0.4% to 1%. Non-recourse fees can be higher.
When Should Accounts Receivable Financing Be Used By Businesses?
Accounts receivable financing can be used in a number of situations.
When a business finds itself short on cash and unable to pay its suppliers, getting cash as soon as possible is critical. A traditional business loan isn't an option in this case since it will take too long to process. Accounts receivable financing can meet the timeline needed by the business.
For this business, whatever event(s) led to the shortage of cash is the bigger issue. If revenues are declining, accounts receivable financing is only a temporary fix to a systemic problem. Eventually, the business won't be able to get any kind of financing and may ultimately have to file for bankruptcy.
A business that is financially sound may find it doesn't have enough money to finance capital expenditures needed for a growth project. The project is time-sensitive. Meaning, the business must start the project within the next month so it can be finished by the end of year deadline. Otherwise, the business will miss a great opportunity. Current cash flow isn't enough to finance the project. This makes accounts receivable financing a great option.
Outsourcing Of Collections
Some customers tend to take a long time to pay. Eventually, some don't pay at all. For a business that doesn't want to deal with such customers, it can use accounts receivable financing to outsource the collection of payment from these customers. Existing customers with great credit won't be affected because accounts receivable financing allows businesses to be selective about which invoices to finance. The business also frees up its time to focus on daily operations rather than collections.
How Quickly Is Money Advanced?
Unlike a traditional loan, which can take weeks or months for a decision to be made, accounts receivable financing can be approved within 24 hours. Funds can be deposited within 1 to 2 business days.
Accounts Receivable Financing Vs Invoice Factoring
Accounts receivable financing and invoice factoring are often used interchangeably. However, the two are very different. Accounts receivable financing has already been described above so we'll look at how invoice factoring is different.
With invoice factoring, a percentage of the value of outstanding invoices are advanced to the business minus a fee. The remaining amount is held in reserve. Once customers pay all of the invoices, the reserve amount is advanced minus a fee. With invoice factoring, the lender is called a factor.
Factors assume the entirety of outstanding invoices rather than just certain ones that the business chooses. Customers must also pay the factor directly. This means the business loses control of payment collections. Such a change can have a negative impact on customers, since it may look as though the business is having problems or has even been bought out. Communicating and being transparent with customers about the factor's role is crucial for maintaining good customer relations.
Businesses who are in need of money immediately and want to unlock the cash in their accounts receivable can turn to accounts receivable financing. While fees are higher than traditional business loans, approval and transfer of funds can all happen in less than a week. Accounts receivable financing is also less intrusive than invoice factoring since the business can choose to continue collecting payments directly from its customers.
- Accounts receivable financing is similar to a traditional business loan, minus the monthly payments.
- The two types of accounts receivable financing are recourse and non-recourse.
- You should use accounts receivable finances when your company is low on cash, if you need to grow your business fast, or if you outsource some of your operations.
- Money is usually funded between one to two business days of when you send in the invoice.