What Is Accounts Receivable Financing?
Accounts receivable (AR) financing is a type of financing arrangement in which a company receives financing capital related to a portion of its accounts receivable. Accounts receivable financing agreements can be structured in multiple ways usually with the basis as either an asset sale or a loan.
Accounts receivable financing allows companies to receive early payment on their outstanding invoices. A company using accounts receivable financing commits some, or all, of its outstanding invoices to a funder for early payment, in return for a fee.
What are the three primary types of receivables finance?
- Asset-based lending (ABL): Also known as a business line of credit or traditional commercial lending, asset-based lending is an on-balance sheet technique and typically comes with significant fees. Companies commit the majority of their receivables to the program and have limited flexibility about which receivables are committed.
- Traditional factoring: In factoring, different than reverse factoring, a business sells its accounts receivable to a funder – but the initial payment is for less than the full amount of the receivable. For example, a company may receive early payment for 80 percent of the invoice amount minus processing fees. Compared to asset-based lending, companies have more flexibility in choosing which receivables to trade, but funder fees can be high and credit lines may be smaller. As with ABL, any factored receivables are recorded on the company’s balance sheet as outstanding debt.
- Selective receivables finance: Selective accounts receivables finance allows companies to pick and choose which receivables to advance for early payment. Additionally, selective receivables finance enables companies to secure advanced payment for the full amount of each receivable. Financing rates are typically lower than other alternatives, and this method may not count as debt based on the program structure. Because selective receivables finance stays off the balance sheet, it does not impact debt ratios or other outstanding lines of credit.
Loan or Asset Sell
AR financing can take various forms. The business owner using this method must understand if their agreement is structured as a loan or as a sell of assets. Accounts receivable are unpaid and outstanding bills that are due to a business. On a balance sheet, these items fall into the category of a current asset and are seen as one of a company’s liquid assets. Liquid assets are those possessions that can be turned into cash easily,
Most of this type of financing takes the form of a sell of company assets. Here, the due accounts are sold to another company in return for cash. The lender will usually pay only a portion of the total AR value to the business. Once sold, the lender assumes the responsibility of collecting the debt.
Loan and Collateral
When the AF financing is structured as a loan, the AR book is seen as collateral to the loan. The company retains the ownership of the AR book and the duty to collect on those debts. Business owners should ensure that the deal has a prime rate, which in essence is the varied interest amount. They should find out how the prime rate is calculated and whether it is tied on the factoring. Keep in mind that a prime rate is an essential part of accounts receivable financing.
Dating the Invoice
The purchase date is another element of the agreement that you must put into perspective. In normal cases, invoices are payable within more than 180 days. Factoring companies prefer invoices that are newer and have a longer collection shelf-life than those that are near term or delinquent.
Length of the Agreement
The length of the AR financing agreement is important for the business to consider. Whether the AR agreement goes for months, a year or several years can have varying impacts on a company. Be sure that you are well aware of the length of the agreement, and whether a short-term or long-term agreement will be vital for your business.
Understanding Accounts Receivable Financing
Accounts receivable financing is an agreement that involves capital principal in relation to a company’s accounts receivables. Accounts receivable are assets equal to the outstanding balances of invoices billed to customers but not yet paid. Accounts receivables are reported on a company’s balance sheet as an asset, usually a current asset with invoice payment required within one year.
Accounts receivable are one type of liquid asset considered when identifying and calculating a company’s quick ratio which analyzes its most liquid assets:
Quick Ratio = (Cash Equivalents + Marketable Securities + Accounts Receivable Due within One Year) / Current Liabilities
As such, both internally and externally, accounts receivable are considered highly liquid assets which translate to theoretical value for lenders and financiers. Many companies may see accounts receivable as a burden since the assets are expected to be paid but require collections and can’t be converted to cash immediately. As such, the business of accounts receivable financing is rapidly evolving because of these liquidity and business issues. Moreover, external financiers have stepped in to meet this need.
The process of accounts receivable financing is often known as factoring and the companies that focus on it may be called factoring companies. Factoring companies will usually focus substantially on the business of accounts receivable financing but factoring in general may be a product of any financier. Financiers may be willing to structure accounts receivable financing agreements in different ways with a variety of different potential provisions.
Let’s say Company XYZ sells widgets. It has about $1 million in receivables from customers who have not paid for their widgets.
Company XYZ needs cash right away because it is trying to finish building a factory. A/R is an asset, and as such, it appears on the balance sheet. In particular, A/R is a current asset, meaning that the amount owed is expected to be received within the next 12 months.
Company XYZ calls a factor, which purchases the receivables for $750,000. In the deal, Company XYZ gets $750,000 right away, and the factor gets the right to all the money from the receivables ($1 million). A factor is a financial institution that purchases receivables from a company. The factor then assumes the risk of customers paying late or not paying at all.
Why is Selective Receivables Finance Often a Preferred Option?
Compared to asset-based lending and traditional factoring, selective receivables finance delivers cash flow gains more efficiently and often at lower costs and risks. Here’s why:
- Not counted as debt: When structured properly, selective receivables finance stays off a company’s balance sheet and therefore has no impact on outstanding loans or future requirements for lines of credit and similar funding.
- Companies choose which receivables are paid early: Companies can choose which receivables they want to submit for early payment rather than offer up their entire rolling book of receivables. As a result, they can more closely control their ability to trade off cash flow gains and funding costs.
- Flexibility to choose when to participate: Selective receivables finance allows companies to participate only when they need to. This is key for businesses that experience seasonal demand or during periods of economic volatility.
- Ability to tap into multiple funding sources: Unlike other options, selective receivables finance allows companies to incorporate multiple funders into a program. This reduces the risks inherent in relying on a single financial institution (including when a bank will restrict liquidity due to changes in their own circumstances).
- More favorable pricing: By incorporating multiple funding sources, selective receivables finance enhances price competition.
The primary benefit of accounts receivable financing is that you collect most of the money owed in a short time. These funds are then available to pay expenses. Because you sell the invoices, rather than borrowing against them, you do not pay any interest and you do not have to list an additional liability on your balance sheet. Factoring companies normally share their credit analysis of customers with you, so you gain information that will be useful when doing business with these customers in the future.
When you sell receivables to a factoring company, you are still liable if a customer does not pay the bill. For this reason, you need to be sure customers are creditworthy. Another consideration is that the fees, although usually small, reduce your profit margin. It is important to make certain the factoring company is professional and mindful of customer relations. An aggressive collection policy on the part of the factoring company may alienate your customers.