What is accounts receivable financing?
Accounts receivable financing, AR financing or invoice financing is a business agreement whereby the business borrows capital against the value of its accounts receivable (AR). The lender advances a majority (80% – 90%) of the business’s unpaid invoices in the form of a loan or asset-backed security, etc.
In summary:
Who asks for capital against the outstanding invoices? The business.
Who gives the capital? Lending company or factoring company.
Capital is paid under which agreement? Loan, asset-backed security or line of credit.
What is set as collateral? The total amount of the invoices.
Steps involved in accounts receivable financing
Accounts receivable financing transforms unpaid invoices into instant cash flow. You can use that capital to pay for overhead costs, payroll and other expenses. Here are the steps:
- You submit your invoices to a lending or factoring company. These invoices constitute the total money your customers owe you for the supplied product or service.
- The lending company accesses the creditworthiness of your customers & business. This is done to calculate the assisted risk which may affect the fee the lending company charges.
- The lending company advances the capital. This capital is generally 70% – 90% of the invoice amount. They also decide on the fee they will charge. It could be a percentage of the advanced amount, a percentage of the total invoice amount or a percentage of the total invoice amount per week.
- Your customers pay the outstanding invoices. That amount (plus the fee) is given to the lending company and they return the remaining amount to you.
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Example of accounts receivable financing
Say, you run a transportation business. You just invoiced one of your customers £10,000 on the condition that he will pay you after 28 days. You then decided to opt for accounts receivable financing. The lending company agreed to pay you 80% of the invoice amount and a fee of 1% of the invoice amount every week.
Total invoice amount = £10,000
Advanced amount = 80% of £10,000 = £8,000
Fee of lending company = 1% of £10,000/week = £100 x 4 = £400
You receive £8000 from the lending company.
After 28 days, on the due date, your customer pays you £10,000, you keep £1600 of the customer payment and repay the rest to the lending company (£8000 + £400 = £8400). As a result, you will receive a total of £9600 from receivables instead of £10,000.
Types of accounts receivable financing
Factoring
Invoice factoring is a process in which the business sells its invoices to a factoring company at a discount. You will receive an advance payment of 70% – 90% of the invoice value from the factoring company.
After this, the company assumes the responsibility of collecting payments from the customers. Once the payments have been received, they pay you the outstanding amount minus the fee which is generally 1% to 5%.
Asset-backed securities
Asset-backed securities (ABS) involve the conversion of a business’s receivables into a financial product that can be sold to investors. Through a process called securitisation, the receivables are first transferred to a special purpose vehicle (SPV), which then issues the ABS to investors.
The investors provide the company with cash flow and receive interest in return.
Accounts receivable loans
It is a type of financing where a business uses its outstanding invoices as collateral to secure a loan from a lending company. The lending company provides a cash advance based on the value of the receivables and charges a fee which is a percentage of the total invoice amount.
Advantages of accounts receivable financing
AR financing comes with various benefits for your business.
- Immediate capital access: You get immediate cash for your business, generally within 1-3 days of applying. This capital can help you pay for expenses or cover any emergency costs.
- Flexibility in terms of structure: Accounts receivable financing provides flexibility in terms of structure – it can be structured as a loan or asset-back security. Moreover, it’s tied to the value of receivables. As sales grow, the amount of available financing can increase accordingly.
This can be quite useful for businesses that experience seasonal spikes as they can get more funds from lending companies during their peak periods, ensuring the operations keep running smoothly. - Improved cash flow: Instead of waiting for the customers to pay outstanding invoices, you can get immediate cash from the lenders which results in improved cash flow. This can be used to meet payroll and handle expenses.
- No collateral needed: Unlike traditional loans, you don’t need specific collateral to get money from the lending or factoring company. Your invoices serve as the collateral.
- Access to expertise: Many lending companies offer valuable insights in credit management and collections. For example, they can provide you with expertise about how to better assess the creditworthiness of potential clients that may help you reduce the risk of non-payment in the future.
Disadvantages of accounts receivable financing
There are a few cons of AR financing as well.
- Cutting of profits: The factoring (or lending) company charges a fee when providing you immediate cash. It is usually 1% – 5% of the total invoice amount. Over time, these fees can add up and may reduce your profits. For example, if the fee is 5% of the invoice amount, you will have to pay £500 on an invoice amount of £10,000.
- Damage to customer relations: Accounts receivable financing typically involves the lending company being in charge of taking payments from the customers. This may lead to weak customer relationships especially if the lending company employs aggressive collection tactics. The customers may feel harassed and burdened.
That being said, accounts receivable financing is almost always beneficial for businesses with invoices that take 30 to 90 days to be paid. This is because they provide immediate cash which you can use in operations to grow the business and streamline your processes for enhancing profit.
Difference between accounts receivable financing and factoring
There are many differences between invoice financing and factoring. A few are discussed below.
| Accounts receivable financing | Accounts receivable factoring |
|---|---|
|
The ownership of the invoices is retained by the business. |
The ownership is transferred to the factoring company. |
|
The business is usually responsible for collecting the payments from the customers. |
The collection of payments is the responsibility of the factoring company. |
|
It is structured as a loan based on the value of invoices. |
It involves selling invoices to a third party for immediate cash. |
|
The business retains the credit risk. |
The factoring company assumes the credit risk for purchased invoices. |
|
Suitable for businesses who want to retain control over the payment and customers while needing immediate cash flow. |
Suitable for businesses who are willing to transfer credit risk while needing immediate cash flow. |
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Accounts receivable lenders are financial institutions/companies that provide financing options to businesses using their unpaid invoices. They provide immediate cash to them and charge a particular fee for it (fixed percentage or interest).
Payable financing is a type of invoice financing that businesses get against their supplier’s unpaid invoices. Receivable financing is the type of financing that borrows money against outstanding invoices of the customers.
Accounts receivable financing involves borrowing funds as a loan against your invoices, while AR factoring involves selling your invoices to a third party to get cash in advance. Both methods incur a fee that the lender (or factoring company) charges to the businesses
