Every business owner at some point runs into a situation where they need more cash for their small business.
Maybe they have a lot of open accounts, or maybe they have a big opportunity to grow the business but just don’t have the funds available to take advantage of it.
Or maybe they just need to make payroll.
Whatever the situation, one of the best ways to get the working capital you need quickly is by using accounts receivable financing.
Accounts Receivable Financing
When it comes to accounts receivable financing, there are primarily two different forms.
One is known as accounts receivable factoring, and the other is a more traditional loan, where you use your accounts receivable as collateral is accounts receivable financing through a bank.
In this article, we’re going to primarily focus on factoring, which is the more commonly used form of accounts receivable financing.
How does accounts receivable factoring work?
To better understand accounts receivable financing, let’s walk a hypothetical business through the factoring process:
Janice Green owns a small business that specializes in cleaning office buildings. Her company, AAA Cleaning, has been around for a little over a year, and she has quickly gained a large book of clients. Just this last week, she landed a dream client, a large office park with multiple buildings that will effectively double her revenue overnight.
To keep up with the amount of work she’ll have from the new client, she has to hire 15 new employees and buy the necessary cleaning supplies.
Unfortunately for her, she doesn’t have enough cash, and with AAA Cleaning being a relatively new company, her line of credit doesn’t quite cover it. She has a lot of incoming capital from her other clients, but since she requires payment in 60 days, it doesn’t look like she’ll have the necessary funds in time to buy the supplies and also make payroll.
Fortunately for Janice, she found a factoring company that will work with her. She sends her invoices over to them and fills out some paperwork.
In less than a week, the factoring company approves, buys several of her invoices and deposits the money in her bank account. This provides Janice with enough working capital to hire the 15 employees, as well as buy the necessary cleaning supplies. She fulfills the order, makes payroll, and continues to grow her thriving cleaning business.
In this story, Janice was able to take advantage of an opportunity to grow her business, while also avoiding debt. Accounts receivable factoring can be a great financial tool, but you need to decide if it’s right for you and your small business. We've compiled four top reasons to use accounts receivable financing in your small business.
Why Use Accounts Receivable Financing?
Reason #1: With accounts receivable financing, you generally get cash faster
Applying for a small business loan through a traditional lender can be a long and rigorous process. Not only do you have to supply a large amount of paperwork, you also have to wait for their decision, which can take weeks if not months.
By the time you get your money, the opportunity you needed it for might be gone.
With accounts receivable financing, a decision can come down to you within a week, if not within a few days.
Financial institutions that offer factoring generally have the process down to a science, where they can quickly check your accounts receivable, along with your customers credit scores. Not only that, once you’ve done invoice factoring with a financial institution once, the next time you use them will go much quicker.
Accounts receivable financing can provide the working capital you need fast, allowing you to capitalize on that big opportunity in front of you.
Reason #2: With accounts receivable financing, your invoices are the collateral
If you’re just starting out, or your business is struggling, it can be difficult to get a small business loan.
Banks typically want collateral, but if you’ve leveraged all your assets for collateral already, you might be stuck.
Fortunately, with accounts receivable financing, your unpaid invoices essentially work as the collateral.
The factoring company you’re working with will take a look at your outstanding invoices, determine the risk and then buy them from you. They're more interested in your customers credit, not yours.
Reason #3: Accounts receivable factoring is based on your customer's credit instead of your own
If you don’t have strong credit, accounts receivable financing can be as great way to get some cash for your business.
Generally, when you sell your accounts receivable to a financial institution, they look closely at your customers, not you.
When they buy your accounts receivable, they want to know exactly how much risk they’re taking.
This can be a great short term solution for your company. When your business is struggling, it can be extremely difficult to find traditional lenders that want to extend a line of credit or a small business loan to your company.
With AR financing, the spotlight is on your customers, not you.
Reason #4: Account receivable financing can help your business avoid going into more debt
When you sell off your accounts receivable through factoring, you don’t actually accrue any more debt. If your debt-to-income ratio is high, going into more debt can be damaging, if not fatal, for your business.
When you use invoice factoring, you don’t actually go into more debt.
With factoring, you’re selling your invoices to the financial institution at a discount, but you don’t have to pay them back after your transaction is complete.
This is a lot safer than overextending and depending too heavily on short term business loans, which can carry a high interest rate.
To successfully run a small business, you need a lot of different tools. When it comes to your finances, accounts receivable financing can be one of the strongest tools you have, as long as you use it correctly.
Why Use Accounts Receivable Financing?
- Get paid faster
- Invoices are collateral to get a loan
- Credit is based on your customers, not your business
- Helps you avoid additional debt