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How Accounts Receivable Financing Works

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Accounts receivable financing, or AR finance, allows you to leverage your company’s unpaid invoices to get the small business funding you need. Also called invoice financing, this funding comes in the form of a loan or line of credit with invoices acting as collateral. Invoice factoring is a type of invoice financing, where lenders would purchase your invoices in exchange for a cash advance.

What is accounts receivable financing?

A company’s outstanding invoices, or accounts receivable, represent the money its customers owe. The business has extended a line of credit to its client, and the client has a set amount of time to produce payment for the product or service the business has delivered.

Accounts receivable financing example

For example, a clothing manufacturer orders $1,000 in 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 it 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’s waiting for payment.

The textile company could use that invoice as collateral for a loan or line of credit — or, if using invoice factoring, sell the invoice to a financing company or factor in exchange for a cash advance — typically between 60% and 97% of the invoice’s value. It would receive the remaining amount, minus the lender’s fee, when the clothing manufacturer paid its bill.

Is accounts receivable financing right for your business?

Some businesses choose to use AR finance on a regular basis to establish stable, predictable cash flow. This allows business owners to focus on core competencies like product development and business growth, rather than expending resources on invoice collections.

Accounts receivable financing may be right for a company that needs cash to invest in the business, but doesn’t qualify for traditional business loans. Invoice financing may also be a good option for businesses that are risk-averse — you’re borrowing money your business has already made, versus money you hope to make in the future.

Pros of AR finance

 Opportunity for quick access to cash tied up in unpaid bills.

 Invoices are typically the only collateral required.

 Borrowing against money already promised to your business.

Cons of AR finance

 Borrowers may need strong credit history and quality invoices to qualify for invoice financing.

 Business owners may need to pay the invoice if customers default.

 Lenders may cancel ongoing financing if too many customers default on invoices.

Accounts receivable financing vs. factoring

Both invoice financing and invoice factoring allow business owners to access funds from unpaid invoices, but the process varies for the two products. As discussed earlier, invoice financing often comes in the form of a loan or line of credit with invoices simply serving as collateral.

Invoice factoring, on the other hand, requires business owners to sell their invoices to a factoring company. Selling receivables means the factoring company assumes control of the invoice, and the business’s customers make their payments to the factoring company, rather than the business itself. After customers pay their bills, the factoring company collects a fee before passing along the remaining amount to the business owner.

Which one is right for you?

Factoring is a common solution for small and mid-size companies, while larger businesses are more likely to turn to invoice financing. Businesses with limited credit history are often more likely to qualify for invoice factoring than financing, as the credit quality of the business’s customers would be more important than the credit history of the company itself. However, invoice factoring is generally more expensive than invoice financing, although time to funding may be faster.

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How to apply for accounts receivable financing

1. Take stock of your open invoices.

Before applying for accounts receivable financing, determine how much money you need and take stock of your open invoices. If you’re considering invoice factoring, know that while some factoring companies allow you to select certain invoices to finance, others prefer to purchase all of your open invoices. With invoice financing, you could choose which specific invoices you’d like to finance. Decide what your goal is at the start and carefully research accounts receivable financing providers.

2. Gather documents needed to apply.

The documentation you’ll need to apply for accounts receivable financing will vary based on the lender you choose. You’ll most likely need to provide your accounts receivable/payable report; this document should detail the status of at least 90 days’ worth of invoices. The lender or financing company will use this report to verify your customers and the amount they owe you.

Additional documents you may need:
  • Basic business details, such as your business license, articles of partnership or incorporation or a tax identification number
  • Recent tax returns or bank statements
  • Credit report
  • Information about outstanding invoices

Expect the lender or financing company to check your credit score when you apply. While invoice financing may require a higher credit score than invoice factoring, you may qualify with a score of at least 530 or higher.

3. Submit an application and get your funds.

For many non-bank lenders, you can complete an accounts receivable financing application online. Once approved, setting up asset-based financing may take as long as three to four weeks, depending on the amount you’re receiving and whether it’s in the form of a loan or credit line. When setup is complete, you could receive your funds in one to two days; invoice factoring may be faster.

How much will accounts receivable financing cost?

The cost of accounts receivable financing would depend on a number of factors, including the quality of invoices and estimated difficulty collecting on those invoices. There’s often a flat, one-time upfront fee that would cover the lender’s underwriting and origination costs. This fee would be based on the size and complexity of your financing arrangement. If you choose to occasionally finance invoices rather than set up an ongoing accounts receivable financing agreement, you may have to pay this fee each time you obtain funds.

You’d also owe an ongoing processing fee each time a customer pays an invoice. The fee would be a percentage of the invoice. Lenders would base your fee rate on your sales volume and the overall risk of the transaction. The fee rate could change depending on how long invoices remain outstanding.

Individual lenders and accounts receivable financing companies would have their own rate and term structure. Shop around and compare quotes from several lenders to make sure you’re getting an invoice financing deal that works for your small business.

 

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