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.
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.
Factoring. Factoring is the most common form of accounts receivable financing for smaller businesses. Under the factoring approach, the borrower sells its receivables to a factoring institution. The receivables are sold at a discount, where the discount depends on the quality of the receivables.
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Is Accounts Receivable Financing Right for Your Business?
Almost every small business owner who invoices customers has probably received a late payment at some point. In fact, nearly 60% of invoices are paid late. Invoice financing provider Fundbox estimated that if all invoices were paid on time, U.S. small businesses could collectively hire 2.1 million more employees, which would reduce U.S. unemployment by 27%.
Your business might be a good candidate for accounts receivable loans if you invoice business customers and are facing any of the following problems:
- Short-term cash flow shortage
- Cannot meet seasonal demands
- You see a business opportunity but don’t have the cash reserves to capitalize on it
- You need to pay your employees, suppliers, or regular bills while awaiting invoice payments
- You want to reinvest in your business or make improvements
- Your supplier is offering a temporary discount that you want to take advantage of
- You want to hire additional employees to grow your business or fill a seasonal need
In simplest terms, accounts receivable loans provide your business with immediate, flexible cash that you can use for any of your business needs.
This is especially important for businesses that invoice customers for large amounts of money and don’t receive payment for a long time. This might happen with multi-phase contracts, corporate clients, or government contracts.
A business line of credit or business credit card can sometimes tide you over when If you face a cash flow problem. But you might not be able to qualify for an affordable line of credit, or the credit limit might not be high enough on your business credit card. In those cases, accounts receivable financing can be a good option.
Accounts Receivable Financing: Pros and Cons
There are a lot of reasons to use accounts receivable financing to fund your small business. But not every loan product works for every business. Accounts receivable financing is essentially short-term financing, so it can be expensive or simply the wrong choice for certain businesses. Make sure you weigh the pros and cons before going forward.
You’ll notice the last point on our list was featured as both a positive and a negative. Depending on the reliability of your customers and their financial histories, this might be a negative (higher interest rate) or a positive (easy loan approval, low-interest rate). When the cost of accounts receivable financing gets converted to an APR, it comes to around 13% to 60%, but the harder the lender thinks collecting the invoice will be, the higher the APR will be.
For a business with a mediocre financial history, accounts receivable financing might be their best option. Some businesses won’t be able to qualify for traditional bank loans but will be able to qualify for accounts receivable financing.