Understanding Accounts Receivable Financing

Understanding Accounts Receivable Financing

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What is accounts receivable financing?

Accounts receivable financing (AR financing) turns your unpaid invoices into instant cash flow. The amount you can borrow through accounts receivable financing is based on the value of your outstanding invoices, typically providing a percentage of their value minus fees.

The principle is simple: you've done the work, sent the bill, but your customer hasn't paid you yet. Instead of waiting, a lender gives you a portion of the invoice amount upfront, typically 80-90%. They then collect the full payment from your customer, keeping a fee for their services.

In essence, receivable financing is a way to leverage your existing assets (unpaid invoices) to get the funding you need right now. This makes it a great solution for businesses with long payment cycles or those who need a quick cash injection to cover expenses, invest in growth, or handle unexpected challenges.

How does accounts receivable financing work

Accounts receivable financing is a short term business financing option, so the process is relatively straightforward and fast:

  1. Invoice Submission: You send your outstanding invoices to the financing company. They'll review them to assess the creditworthiness of your customers and the overall risk.
  2. Approval and Advance: Once approved, you'll receive a percentage of the invoice value upfront. This cash injection happens quickly, often within 24-48 hours.
  3. Customer Payment: Your customers pay their invoices directly to the financing company. They handle all the collections, so you can focus on running your business.
  4. Remaining Balance and Fees: Once your customer pays the full invoice, the financing company pays you the remaining balance, minus their fee. This fee is typically a percentage of the invoice value and varies depending on the provider and the specific terms of your agreement

What are the rates for accounts receivable financing?

Accounts receivable financing isn't a loan, so it doesn't have an interest rate. Instead, providers charge a fee, usually a percentage of the invoice value. This fee can vary widely depending on several factors:

  • The size of your invoices
  • The creditworthiness of your customers
  • The age of your invoices
  • The provider you choose

A note on language – some providers might offer a "discount rate" instead of a percentage fee. This is simply the inverse of the fee. For example, a 3% fee is equivalent to a 97% discount rate.

What is accounts receivable financing for?

ARF is best viewed as a short-term fix. You have money coming, but you need it now, so you’ll settle for a slight reduction in exchange for speed of payment. This makes it a valuable tool for when you’re short on cash, such as:

  • Covering unexpected expenses or emergency cash flow issues
  • Times when cash inflows are out of sync with fixed expense, such as payroll or rent
  • Restocking inventory to avoid stockouts

Accounts receivable examples: financing vs factoring

There are two main types of accounts receivable financing examples that business owners should be aware of:

Invoice Finance

Invoice finance is a version of ARF where you retain ownership of your invoices. This means you're still responsible for managing your customer relationships and collecting payments.

  • The advantage is that your customers won't know you're using invoice finance, since they won’t have any contact with your ARF provider. 
  • You can also choose which invoices to finance, giving you more control over your cash flow.
  • In general, this is better for established businesses. Lenders often prefer businesses with a strong track record and reliable customers for invoice finance.

Invoice Factoring

Invoice factoring is a simpler, but less nuanced form of ARF. Here, the factoring company buys your invoices at a discount and takes over responsibility for collecting payments.

  • This means that you no longer need to chase payments, since the provider will do it for you. 
  • You know exactly how much you'll receive upfront for each invoice.
  • Factoring often provides funds even faster than invoice finance.
  • Good for startups or businesses with high invoice volume. Factoring can be more accessible for businesses with limited credit history or those with a high volume of invoices.

Advantages of Accounts Receivable Financing

Accounts receivable financing offers several key advantages that make it an attractive option for businesses looking to boost their cash flow:

  • Fast Access to Cash: Unlike traditional loans, which can take weeks or even months to process, accounts receivable financing can often provide funding within days. This quick turnaround can be a lifesaver for businesses facing urgent expenses or growth opportunities.
  • Improved Cash Flow Management: By receiving upfront payments for outstanding invoices, you can smooth out your cash flow and avoid the stress of waiting for customers to pay. This can help you cover payroll, pay suppliers, invest in new equipment, or simply keep the lights on.
  • No Need for Strong Credit History: Since the financing is based on your customers' creditworthiness, not your own, businesses with less-than-perfect credit scores can still qualify. This opens up funding opportunities that might not be available through traditional lending channels, especially for newer businesses.
  • Simplified Collections: With factoring, the burden of chasing late payments shifts to the factoring company, freeing up your time and resources to focus on growing your business.
  • Scalable Financing: As your sales increase, so does the amount of financing you can access, making accounts receivable financing a flexible solution that can adapt to your business's changing needs.

Disadvantages of Accounts Receivable Financing

While ARF is a great option for getting your business out of a tight spot, it’s not a long term solution or suitable for all scenarios.

  • Higher Cost: Compared to a bank loan, ARF typically comes with higher fees and interest rates, thanks to the increased risk lenders take on by advancing funds against unpaid invoices.
  • Customer Impact: Factoring involves a third-party (the factoring company) communicating with your customers about payments. This can sometimes lead to misunderstandings or strained relationships if not handled carefully.
  • Not Suitable for All Businesses: Businesses with low invoice volumes, unreliable customers, or highly variable sales might not be the best fit for accounts receivable financing.

Limited Scope: ARF is primarily suitable for managing short term concerns and day to day expenses. This is because the amount you can borrow is limited to a percentage of the amount you’re owed. For businesses looking to finance larger projects or make big changes, other forms of financing are much more suitable and more flexible.

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Alternatives to accounts receivables financing

For businesses looking to make more substantial investments, or avoid the disadvantages of accounts receivable financing, other financial instruments can be more flexible and affordable. 

  • Short-Term Business Loans: Short-term business loans such as iwoca’s Flexi-Loan can be adapted to a range of scenarios, providing a lump sum of cash you repay over a relatively short period, typically 12 months or less. They offer faster approval and funding than traditional loans – in as little as 24 hours – and you can often tailor repayment terms to suit your cash flow. 
  • Bridging Loans: If your business is waiting for a big payment or asset sale to come through, a bridging loan could be the answer. They provide short-term access to capital, often secured against an asset like property or equipment. Bridging loans offer quick access to funds and flexible repayment, but they come with higher interest rates than traditional loans and potential fees if your exit strategy doesn't pan out.
  • Merchant Cash Advances: For businesses with high credit and debit card sales but unpredictable cash flow, a merchant cash advance (MCA) can be a viable option. You receive an advance based on your future card sales and repay it through a percentage of your daily sales. While MCAs offer easy qualification and fast access to cash, they can be expensive due to high factor rates, making them tricky for businesses with low card sales volume.
  • Revolving Credit Facility: A revolving credit facility is a line of credit you can draw from and repay as needed, a bit like a credit card. It's ideal for businesses with fluctuating cash flow or those who want ongoing access to working capital.  You only pay interest on the amount you borrow, and it can help build your business credit. It’s worth noting that interest rates can be variable, and you might need to provide a personal guarantee.
  • Business Overdrafts: A business overdraft allows you to borrow a set amount beyond your account balance when needed. It's a good option for short-term cash flow issues and unexpected expenses. While overdrafts offer flexibility, be careful of interest rates and fees, which can add up quickly if not managed carefully

Optimising Accounts Receivable Beyond Financing

While accounts receivable financing can be a handy tool, it's not a long term solution to manage your cash flow and can in fact hide issues that need attention.  Businesses should consider managing money owed as its own area for process improvement to improve your financial health and reduce your reliance on external financing.

  • Being careful with credit terms: Before extending credit, check potential customers to ensure they have a good track record of timely payments. Establish clear payment terms upfront, outlining due dates and any late fees. You can also take steps to encourage early payment, such as offering small discounts.
  • Invoicing on time: Fast and accurate invoicing is essential. Send invoices promptly after completing work or delivering goods, and make sure they're clear, concise, and easy for customers to understand. Offer a variety of payment options, such as credit cards or online payments, to make it convenient for customers to settle their accounts. 

Working capital management: Beyond invoices, look at the bigger picture of your working capital management. Negotiate better payment terms with your suppliers to give yourself more breathing room. Keep a close eye on your inventory levels to avoid tying up too much cash in stock. And, most importantly, develop a robust cash flow forecasting system to anticipate potential shortfalls and plan accordingly.

Words by
Sean Martin
Article published on
May 29, 2024
Last reviewed on:
May 29, 2024

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