Robert Herjavec of Shark Tank fame says that “cash is the lifeblood of your business.” If cash supplies the life flow to a business, then accounts receivable factoring can be a sort of paramedic that saves a business during times of “blood clot,” when there’s a cash flow crunch. Business owners can improve the financial health of their business by improving accounts receivable management.
Many businesses that sell to other businesses (B2B) offer credit terms. Trade credit, Net D, or vendor credit is established when a business allows its customers 10 to 120 days to pay in full for products and services already rendered. The outstanding invoices become “accounts receivable” for the business, and are placed on the balance sheet as a business asset.
While some businesses are well capitalized to handle the up-to-90-day payment collection process, some are not, and end up with a cash flow gap when cash outflows are stacking up and cash inflows are at a standstill. They fall behind on their accounts payable because payments from their customers aren’t coming in.
Here are some financing options that can help your business weather fluctuations in cash flow.
B2B businesses may be able to get paid faster on outstanding invoices by using invoice factoring. With this type of arrangement, the factoring company will typically purchase or advance payment on most of the invoice amount, and the rest— minus their fee— when the invoice is paid. The factoring company takes over collection of the invoices that are due.
This type of financing is very common in many industries, and it generally doesn’t require the business using it to have strong credit. Instead, the factoring company will likely be more interested in the credit history of the company that owes the invoice.
Accounts Receivable Financing
If a merchant chooses to deal with a cash flow crunch using accounts receivable financing, they do not sell their receivables. Instead, they leave outstanding receivables on the balance sheet and use the asset as collateral for a loan transaction.
The approval amount is usually 60% to 80% of the value of the outstanding receivables. Accounts receivable financing is known as an asset-based lending program, which takes an asset of value that’s already pre-owned, and uses it as security or collateral for a loan transaction. Other than accounts receivables, the types of assets that are usually pledged for asset-based lending programs include, but are not limited to:
- • Commercial equipment
- • Inventory
- • Real estate
- • Luxury cars
- • Commodities
- • Collectibles, antiques and artwork
- • Jewelry
Purchase Order Financing
Before an accounts receivable is created, the merchant has to buy the materials needed in order to render the services or products in question. Sometimes a merchant has a cash flow crunch upfront, and doesn’t have the capital to purchase the necessary materials. This is when another aspect of factoring can be used: purchase order financing.
With purchase order financing, a lender advances capital to the merchant’s material supplier or vendor so the merchant can obtain the materials they need to fulfill a client’s outstanding purchase order. Once the materials are received, the product or service is rendered and payment is collected from the merchant’s customer. Then the lender is repaid from a portion of the revenue, plus a discount fee for service.
The advance amount usually covers the cost of the entire material purchase, or at least 80% of the amount. The lending firm could also decide to open up a vendor line of credit for the merchant, which would allow the merchant to obtain goods and materials from a particular vendor on an ongoing basis.
Merchant Cash Advance
Sometimes even after using any or all of the above options, a merchant might still have a cash flow crunch. In this case, they can call upon another resource—the factoring of credit card receivables, otherwise known as a merchant cash advance (MCA).
With the MCA, there’s a buyer (the MCA firm) and a seller (the merchant). The MCA firm looks at the merchant’s previous credit card processing statements and notes that the business has been doing $60,000 a month in Visa and MasterCard volume over the previous 12 months, for example. Based on those numbers, the MCA firm might offer to buy $72,000 of the merchant’s credit card processing receivables in exchange for advancing them $60,000. Then the MCA firm may keep 15% of the merchant’s daily Visa and MasterCard batches going forward until it collects the full $72,000.
As long as the merchant continues to process $60,000 a month in Visa and MasterCard volume, for example, the MCA firm should collect the full $72,000 in about eight months.
Short-Term Alternative Business Loan
A short-term alternative business loan can help with additional cash flow crunches as well. This product, while similar to the MCA, is an actual loan transaction and not a purchase—or factor—of receivables.
The lending company will note that a merchant is doing $60,000 a month in revenue and might decide to offer a short-term alternative business loan of $60,000, with a $72,000 total payback, on an eight-month term with a weekly fixed payment of $2,250. There will be an origination fee, disbursement amount, fixed payments and fixed terms—all of which are associated with the aspects of a true small business loan.
On-time payments may be reported to various business credit bureaus, which can help build good business credit scores for small business owners that utilize this short-term alternative loan product and pay on time.
Business Credit Cards
A business credit card can improve your business cash flow by giving you more time to pay for business purchases. Some small business credit cards even offer short-term 0% interest rate financing which can be helpful for managing cash flow shortfalls.
Trade Credit Insurance
If your accounts receivables are still sitting on your balance sheet and you haven’t yet decided to factor or finance them, and are planning on waiting out the timeframe of the customer’s payment schedule, you have an option for additional protection: trade credit insurance. This is basically a side commercial insurance policy that covers losses related to customers who do not fulfill their entire payment obligation within the 10 to 90 days specified on the invoice.
Adding trade credit insurance also strengthens the quality of your receivables, which might or might not be a requirement for closing an accounts receivable financing deal. The policy would also provide you more leverage to negotiate better terms with clients. This gives you a competitive advantage and allows you to sign on clients that might have higher-risk profiles.
Keeping Your Business Alive
For a significant percentage of the 29 million businesses in the United States, the fundamentals of their business model might in fact be strong when it comes to creating revenues, competently managing expenses and being able to generate a good profit margin—but the culprit might be a slow-paying customer base.
Inefficient cash flow management is one of the main reasons for early small business failure. However, with the emergency help of accounts receivable factoring and its sister products, the blood of your business can continue to flow and you can avoid the blood clots that might otherwise spell the early demise of your American dream.
Frequently Asked Questions About Optimizing Accounts Receivable
This article was originally written on August 8, 2016 and updated on September 20, 2022.