A Guide to Accounts Receivable Financing

Accounts receivable financing, also called invoice financing, is the process of receiving capital based on a portion of a company’s accounts receivable. The financing is usually structured as either a loan backed by the accounts receivable or as an asset sale that gives the financing company the right to collect the accounts receivable.

Accounts receivable financing can be used by any business big or small that wants to trade their accounts receivable assets for cash. 

Accounts receivable lending represent a risk as assets, because there is a chance that they will not be collected. Converting accounts receivable to cash via a loan or asset sale is a way to mitigate the risk of non-collection. 

It’s also a tool that can be used by companies who need cash quickly. Accounts receivable financing can get them cash immediately, though almost always less money than the total value of the accounts receivable assets.

Accounts receivable factoring is the process of buying a company’s accounts receivable for cash, usually at around 90% of the value. 

Factoring companies and platforms look to buy short term receivables from companies, sometimes as soon as an invoice is created. In the business-to-business world, most companies invoice each other with long terms, generally between 30 and 90 days. When the supplier delivers a good or service to their customer, it costs them money to do so. If they aren't paying for their goods or services until 30 or 90 days later - that can create major cash flow problems. 

Factoring platforms ensure that companies are immediately paid for the goods and services that they invoice. The invoice factoring platform pays the supplier less than what the total receivable is worth and then hopes to make a profit after collection. 

Invoice factoring accounts receivable comes with default risk. The accounts receivable have a chance of being paid late or going unpaid completely with the factoring company taking the financial hit.

Accounts receivable financing is distinct from factoring in who controls the collections process. In account receivable financing, the business maintains control of the receivables it has borrowed against and collects on them. In factoring, the factoring company purchases the unpaid invoices and takes charge of collecting on them.

Accounts receivable financing (or AR financing) can take two different forms: Loans or Asset Sales.

In a loan arrangement, known as invoice discounting, a financial institution will make a loan to a business that is backed by the business's accounts receivable assets. Those assets are put up as collateral on the loan and if the business fails to repay the loan, they will be turned over to the lender.

Accounts receivable assets are not the same as cash, of course. If the lender did foreclose on the company's accounts receivable they would still need to go through the process of collecting the owed money that the accounts receivable represent.

In an Asset Sale, a factoring platform or other financing company will buy another company's accounts receivable assets outright, generally for around 90% of the price. The factoring platform hopes to collect the accounts receivable in a timely manner and make money on the difference between the purchase price and the total value of the accounts receivable collected.

Most businesses don’t make loans. But banks, credit unions and other financial institutions make it the core of their business. A loan made is accounted for as a “loans receivable” not as an accounts receivable.

An outstanding invoice is a bill that has been sent to a customer for a delivered good or service that has not yet been paid. Having outstanding invoices exposes a business to risk because the business has invested cash in delivering the customers order, but has not yet seen revenue on the transaction.

Many business-to-business invoices are payable within 30, 60 or 90 day terms. Businesses can get their outstanding invoices paid soon by more quickly delivering invoices, accepting a wider range of payment types, offering incentives for paying early and by maintaining good relationships with their customers.

Accounts receivable financing allows companies to shore up their cash flow, reduce the risk on their balance sheets and finance new initiatives. They are trading the future value of their accounts receivable portfolio for immediate cash. According to the Time Value of Money, money now is worth more than the same amount of money in the future because it can be used with more certainty and flexibility.

Businesses need enough readily available cash or working capital to pay their employees, expenses, debt obligations and any investments they make in customer orders. If a company makes an unusually large amount of sales in one month that can present a working capital problem. They will need to invest large sums of money to complete and deliver customer orders, but may not be paid for those orders for 30, 60 or 90 days.

Accounts receivable financing can be a good way for a company to acquire the working capital it needs to maintain operations and grow their sales.

Purchase order funding is distinct from Accounts Receivable financing. In purchase order funding, a company receives a loan that they use to produce a customer’s order. Purchase order financing can increase a company’s cash flow, just like accounts receivable financing does, but the cash flow increase occurs earlier in the sales process.

Almost every type of receivable from a reputable and creditworthy company is eligible for financing. But there are some noteworthy exceptions:

• Receivables that are majorly past due are not eligible for financing.
• Receivables that are under dispute from a customer are not eligible for financing.
• Receivables from a customer that is bankrupt or in the process of declaring insolvency are not eligible for financing.
• Receivables that have been billed but are associated with goods or services that have not been delivered are not eligible for financing.
• Receivables that are due from consumers are not eligible for financing.
• Receivables from a customer that is past due on other invoices are not eligible for financing.

These types of receivables represent too great a risk to financiers to make loans against. Accounts receivable financing companies are looking for reliable sources of future revenue to finance against.

Accounts receivable loans work like most loans, but they use a businesses unpaid invoices as collateral. The financing company will lend the borrowing company a lump sum of money - giving them instant cash. The borrower may be charged a fee between 1 and 5 percent of the total loan amount dependent on their size and creditworthiness.

As the collateralized invoices are paid, the borrowing company sends the money to the financing company. After all collateralized invoices have been paid, the financing company pays the balance of money above the loan amount and minus the fee back to the borrower.