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What is Accounts Receivable Financing?

Accounts receivable financing (AR financing) is a business financing option that some small companies pursue to help fund day-to-day operations or business growth. Since it has a lower level of risk than some alternative small business loans, AR financing can be a good fit for business owners who are more comfortable playing it safe when it comes to money.

Pros and Cons of Accounts Receivable Financing

As with any financing method, there are good things and some not-so-good things associated with receivables financing. One of the most compelling benefits of AR financing is that businesses can get cash quickly. Invoices are usually financed and funded within a day or two, whereas alternative business loans like traditional bank loans can involve a lengthy process and waiting period. Businesses don’t even have to wait out the terms they extended to customers; invoice factoring delivers cash almost immediately. Another primary benefit of accounts receivable financing is that invoices serve as collateral, which makes this funding method accessible to businesses that might not meet the prerequisites for more traditional options that demand a significant operations history, robust credit score, and physical assets.

One of the most obvious disadvantages of AR financing is that it involves fees that are comparatively higher than many other business funding options. Receivables financing can be frustrating for a business since part of the fees are based on how long it takes for the client to pay the invoice, a matter in which the business has no control. With most other types of financing, the business can make conscientious decisions about when and how to pay off their debt, knowing this might affect the overall cost it incurs. With accounts receivable financing, the business is powerless to the factoring company’s collections process and the client’s payables department.

How does Accounts Receivable Financing Work?

To understand accounts receivable financing, it’s important to first grasp “accounts receivable.” Accounts receivable means a company’s outstanding invoices or the money it is owed by its customers. The term signifies that a business has a right to receive payment from its clients’ accounts because it has delivered a product or service. Basically, the business has extended a line of credit to its client, giving the client a set amount of time to produce payment. For example, if a clothing manufacturer orders $1,000 of fabric from a textile company, instead of requiring upfront payment, the textile company might extend terms and invoice the clothing manufacturer for the $1,000, giving them 30 days to pay (i.e. “Net 30” payment terms). That $1,000 is considered part of the textile company’s accounts receivable over the period during which it is waiting for payment.

Accounts receivable financing is a financing arrangement in which a company uses its accounts receivable as collateral. An AR financing company (also known as a factoring company) essentially buys a business’ outstanding invoices at a discount (usually about 70 to 90 percent of the total) and then collects on the invoices. Once the factoring company collects on the invoices, it pays the business the remainder of the total minus a factoring fee. The benefit to the business is immediate cash. The benefit to the factoring company is that it makes money on fees.

How can Accounts Receivable Financing Help a Business?

Companies use AR financing for a variety of reasons, but the funding method is often best suited for urgent situations when a business needs immediate access to cash to fill a gap in cash flow or to take advantage of an opportunity. For example, an ice cream company that does most of its business in the warmer months might need to use accounts receivable factoring to meet payroll on time in January when orders are slow. Or, a bakery might find a great deal on a used commercial oven on Craigslist and need extra cash as soon as possible to snatch it up before a competitor does.

Some businesses do choose to use AR financing on a more regular basis to establish a stable, predictable cash flow. Though it involves fees, the cost is worth it for some small businesses, as it lets them focus on core competencies like product development and business growth rather than expending resources on invoice collections. In fact, some companies do away with an accounts receivable department entirely in lieu of invoice factoring.

Accounts receivable financing can also be right for a company that needs cash to invest in the business, but doesn’t qualify for traditional loans or just doesn’t have the resources to devote to the typically lengthy loan application process. AR financing is also a good option for businesses that are risk-averse, since it involves money it’s already made rather than money it hopes to make in the future.

How to Apply for Accounts Receivable Financing?

Before applying for AR financing, you’ll need to determine how much money you need and which invoices you’ll finance. Some companies choose only to factor the invoices of customers that take longer to pay, others factor them all, and others will factor just what they need for a specific purchase. Decide what your goal is upfront.

Though the documentation you’ll need to apply for invoice factoring will vary based on state and local requirements, you will definitely need to provide your accounts receivable/payable aging report. This document should detail the status of at least 90 days’ worth of your business’ invoices. The factoring company will use this to verify your customers and the amount they owe you. They will also likely run a credit check on them to evaluate the difficulty of securing payment. Additionally, the factoring company will probably request sample invoices from your business for assessment.

Before pursuing accounts receivable financing, you’ll also need to access any legal documentation you have proving that your business is legitimate, owned by you, and properly established. This might include a local business license, articles of partnership or incorporation, or a tax identification number. Some factoring companies may also request recent tax returns.

Finally, you’ll need to complete the factoring company’s application paperwork. Most of the time, this can be done online and you should hear back within a day or two with an offer. Since the process is comparatively quick and simple, you can take your time to review your options, shop around, and find the best factoring match for your needs.

How Much Will Accounts Receivable Financing Cost?

Factoring companies consider a number of things when determining the rate at which to procure a business’ invoices. Money owed by large corporations is believed more valuable than money owed by small businesses. Newer invoices are more valued than old ones. Pricing really boils down to how difficult the factoring company thinks it will be to collect on the invoices – the harder the work, the lower the amount it is willing to pay upfront. The factoring company will generally offer around 85 percent of the total value of the invoices, though it can range from about 70 to 90 percent.

The remaining percentage of the total invoices is held in reserve until the factoring company is able to collect. Before paying the difference, the factoring company will charge a processing fee (about 3 percent) as well as a factor fee based on how long it took to collect on that invoice. Usually, the fee is charged weekly and amounts to about 1 percent of the total invoice.