Introduction
Accounts receivable (AR) is the amount of money that a company is supposed to receive from its customers in lieu of goods/services sold. It forms a significant part of the balance sheet, and companies depend heavily on their AR conversion for cash flow. However, payments may get delayed. So, if a business needs cash urgently, it can choose to finance its accounts receivable.
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What is accounts receivable financing?
Accounts receivable financing is a provision businesses have to raise capital by placing their pending AR as collateral. It is beneficial when businesses need capital and cannot secure a bank loan. There is a small fee involved that the financer charges in this arrangement.
How does receivable financing work?
Suppose Company A gets an order to produce 200,000 pillow covers for $500,000. However, it needs $300,000 in capital to fulfil the consignment. So, it can either take a loan from the bank or get a third party to finance up to 90% of the invoice keeping it as collateral.
Once the order is fulfilled by company A with the money it received from the third-party, it is expected to collect the payment from its customer. Then it will pay the third party the financed amount and the agreed-upon fee.
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Types of accounts receivable financing
There are two primary types of accounts receivable financing:
- Factoring: In this method, businesses can get anywhere between 70%-90% of their invoice value from a third party called the factor. The third party will be responsible for collecting the payment from the customer and paying the remaining amount to the business after taking their fees.
- Invoice discounting: It is similar to factoring but here, businesses get a higher percentage (around 90%) of their invoice value as cash funds. However, they will be responsible for collecting the payment from the customer and paying the financier the received amount and the fees.
What are the benefits and drawbacks of AR financing?
| Benefits |
Drawbacks |
| 1) It is faster than taking a traditional loan from the bank. It usually takes less than a day for the process to be completed. |
It can be expensive depending on the quality of the invoices, the industry you are in, and the third-party financier. |
| 2) AR financing involves keeping your pending invoice as collateral. It doesn’t require your business to have a good credit history. |
The ability to finance your invoice will be dependent on the customer. So, if your customer doesn’t have a good credit history, the financing fee might be high, or you won’t be able to finance the AR at all. |
| 3) Companies can pass on their collection efforts to a third-party company called a factor, who will collect the payments for them in exchange for a fee. |
Companies lose control of how the third-party financier interacts with the client while collecting the payment, which could ruin business relationships. |
| 4) There is no need to give other assets as collateral to get the cash. |
If the customer doesn’t pay, the business will be responsible for that. |
What is the best receivable financing option?
Businesses can choose Invoice discounting when they do not want to give control over their invoices and customer interactions. On the other hand, factoring is a good option for companies if they want to outsource the collections process.
How to choose the right receivable financing company?
FAQs
What is the difference between accounts receivable financing and inventory financing?
AR financing is money that’s obtained by selling an invoice or using it as collateral to fulfil the order placed by a customer. On the other hand, inventory financing is when a business raises funds by pledging some or all of its stock as collateral.
What is the difference between accounts receivable financing and factoring?
In AR financing, the control of the invoice stays with the business, and they are responsible for collecting the payment, whereas in factoring, the third party is responsible for the same.
