How Accounts Receivable Financing Works

How Accounts Receivable Financing Works

Whether you’re trying to expand your business or simply make ends meet, cash flow constraints are one of the biggest challenges that many small businesses face. They can be stressful. They can be discouraging. They can even drive some companies right out of business.  

But here’s the good news. Cash flow problems can typically be dealt with if you have the right plan. This is true whether spending mistakes led to your cash flow shortage or other circumstances entirely. 

For example, cash flow problems are especially common in businesses where there’s a time gap between the delivery of a good or service and receipt of payment from a customer. Depending upon how a business is structured, customers may take as long as 15, 30, 60, or even 90 days to pay their invoices after a good or service has been delivered.

Another culprit that can sometimes cause cash flow and working capital issues can actually be success itself. This might occur when company sales are coming in faster than incoming revenue. 

Regardless of the cause of the shortfall, many businesses will turn to various invoice financing options to make ends meet until revenue has a chance to catch up. One such funding option for businesses that need an influx of cash is known as accounts receivable financing. 

How Does Accounts Receivable Financing Work? 

When your customer owes you money that it hasn’t yet paid, the outstanding payment due to your business is known as an “account receivable.” It’s money your business is owed for goods or services that have already been delivered to customers. 

For small businesses, accounts receivable could be the key to unlock a number of financing options to keep things running smoothly. 

Here’s how it works. The Comptroller of the Currency (Administrator of National Banks) describes Accounts Receivable and Inventory Financing as a way that borrowers leverage assets to obtain financing. In simpler terms, the money your customers currently owe to your business may be used to help you qualify for loans or cash advances for your company. 

Accounts receivable financing, also known as AR financing, should not be confused with factoring which is discussed more below. While both types of financing can help you free up money that’s currently held up in unpaid debts, the way they work isn’t the same. 

AR financing uses your outstanding invoices as a form of collateral to help you get approved for a loan program or cash advance for your business. But unlike other financing options, with AR financing you don’t sell your invoices to a third party. Instead, you remain responsible for following up with and collecting payments from your customers. 

Every finance company is different, but most AR lenders will not offer you a 100% advance on your company’s unpaid invoices. Rather, you’re more likely to see offers of advances at 70% to 90% of your invoices’ value (sometimes less). In return for advancing you a portion of the money before the invoices are actually collected, an AR financing company charges fees (more on those below) that are often quite high. 

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What Is Factoring? 

If you’ve spent some time researching different accounts receivable-based financing options, you’ve likely come across the term accounts receivable factoring. Unlike AR financing, described above, factoring involves the sale of a business’ accounts receivable to a third party.

With a factoring agreement, a third-party factoring company actually buys your outstanding invoices from you, albeit generally at a reduced rate. Your ability to qualify for an advance and, if approved, the value you receive for invoices may depend upon factors such as:

  • The Age of the Invoices (Newer is Better)
  • The Quality of the Account Receivable
  • The Risk Level of Your Customers
  • Your Credit Score (Potentially Business and Personal) 
  • Other Business Factors (The Size of Your Company, etc.) 

Accounts Receivable Financing vs. Factoring

Both AR financing and factoring can be a decent funding solution for companies that need quick access to short-term funding in an emergency, but neither option is typically cheap. Here’s a look at some of the pros and cons associated with these types of receivable-based financing options. 

Pros and Cons of Receivable-Based Financing (AR Financing and Factoring)
Pros Cons
Good for cash flow emergencies.  These financing options traditionally have high interest rates — often higher than small business credit cards.
Paperwork is usually minimal and there are fewer hoops to jump through in order to receive financing.  You may be responsible to repay money that was advanced if your customers don’t pay their invoices as agreed. 
You may be able to qualify with poor credit or no credit rating.  Your customers might be informed about your factoring relationship. 
If your financing or factoring company reports to the business credit bureaus, the account could potentially help you to build business credit.  A percentage of your invoices will likely be held in reserve until your customers pay their invoices. 
You’ll typically receive short repayment  terms.

 

Pricing

The actual cost of accounts receivable financing and factoring can vary widely, just like other forms of business financing. The fees you will be charged can depend upon a number of factors such as: 

  • Invoice factoring companies commonly charge fees in the range of 3% to 5% of the invoice value. 
  • Accounts receivable financing companies often charges fees ranging from 2% to 4% of the invoice value each month. 

The Annual Percentage Rate (APR) on receivable-based financing options are notoriously expensive. They often range from 14% to 68%. 

Whether you’re considering invoice factoring, accounts receivable funding, or any other type of financing, it’s always wise to understand how much money it will cost you to borrow before you make a commitment. This invoice financing APR calculator may be helpful if you’re currently comparing different receivable-based borrowing options. 

Factoring Accounts Receivable Example

One nice feature of invoice factoring arrangements is that fact that, in general, they tend to be pretty transparent when it comes to pricing. Still, it can still be helpful to dig deeper into how the process works before you sign on the dotted line of a new financing agreement. 

Here’s a hypothetical example of an accounts receivable factoring scenario to help paint a clearer picture. 

  • You have an unpaid invoice (already sent to your customer) totaling $100,000. 
  • Your customer is on net-30 terms, so the invoice isn’t due for another month.
  • Because you need fast access to working capital, you reach out to accounts receivable factoring lenders to discuss your borrowing options. 
  • The factoring company offers to give you 80% of your invoice’s value to purchase it.
  • The remaining 20% of the invoice ($20,000) is held in reserve. 
  • Once you accept all of the factoring company’s terms, $80,000 is deposited into your bank account. 
  • The factoring company charges you a fee of 2% upfront ($2,000).  
  • After 30 days, the customer pays the $100,000 invoice. 
  • You’re charged another 2% fee (or $2,000) for that 30-day period of time that the $80,000 was advanced to you. 
  • The factoring company keeps the $80,000 of the invoice that was already advanced to you. 
  • It also takes your reserve of $20,000, subtracts the $4,000 in financing fees ($2,000 + $2,000), and returns the remaining $16,000 to you. 
  • Your total cost for 30 days of factoring was $4,000 and your APR comes out to an astronomically high 60%. 

As you can see, the above scenario might save a company that’s in a financial pinch. However, a 60% APR is certainly not the most affordable way to borrow money for your business.

Accounts Receivable Financing Companies

It’s true that accounts receivable financing can be expensive. But that doesn’t mean it’s automatically the wrong choice. Receivable-based financing can quickly solve emergency cash flow problems for businesses that might have a hard time qualifying for other types of quick financing. 

Do you believe that accounts receivable financing may be a good fit for your business? If so, it’s a good idea to compare available offers before you start filling out funding applications for various lenders. 

You can compare available offers, along with your approval odds, for dozens of funding options through your free Nav account. Additionally, here are a few accounts receivable lenders you might want to consider. 

Alternatives to Accounts Receivable Financing

Finally, remember that accounts receivable financing and its closely related cousins like factoring or purchase order financing probably aren’t the only funding choices available for your business either. You can explore funding options or different lenders through your free Nav account or directly through the Nav Marketplace.

Worried that your credit might hold you back from qualifying for a business loan program or credit card? Check out this helpful guide on how to establish, build, and get the business credit that your company needs to thrive and grow.  

 

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