So much work goes into generating sales. Once you consider marketing, pitching, cold calls, and closing deals, a chunk of time and money goes into bringing customers on.
Then once the work is done, it’s time to get paid.
But a week goes by. Then another. You’ve sent follow-up emails and then finally, after all this time has passed, you get your payment.
It’s natural to think about what you could have done if you had that money sooner. With accounts receivable financing, you can find your answer.
What is accounts receivable financing?
Accounts receivable financing is a way for businesses to access capital through unpaid invoices.
Lenders give businesses money as an advance in the form of a loan or line of credit. The unpaid invoices act as collateral for the lenders.
For businesses with a large sum of outstanding accounts receivables, it gives them an option to turn that uncollected sum into cash now—but it comes with a cost.
How does accounts receivable financing work?
Generally speaking, there are 6 steps in the accounts receivable financing process:
- Decide the amount of desired financing: The business chooses which invoices it wants to finance. Financing is based on the outstanding amounts of the invoices that will be submitted. The business retains ownership of the invoices and is responsible for collecting payment.
- Apply for financing: Applications are submitted to lenders with the selected invoices. The lender will look at the age of the accounts receivable (i.e. days unpaid) and the customer’s payment history. These factors determine whether an application is approved or denied.
- Funding amount is determined: Lenders give you funding based on a percentage of the outstanding accounts receivable amount. Typically, the percentage ranges from 70% to 90% of the amount. If you’re financing based on $10,000 of accounts receivable, you should expect financing ranging from $7,000 to $9,000.
- Use the funds and pay fees: Funds are distributed to businesses to put to use. Instead of interest charged on traditional loans, fees are charged for every week an invoice goes unpaid. It’s best to finance invoices that are likely to be paid on a reasonable timeline to keep fees in check.
- Customers pay the invoices: The customer pays the business directly their outstanding amount. It’s the business’s responsibility to send reminders and collect payments.
- The lender gets paid: The business pays back the borrowed amount and fees to the lender. If any fees are left unpaid, the business must cover them from its cash reserves.
Accounts receivable financing vs. accounts receivable factoring
Accounts receivable financing and accounts receivable factoring (or invoice factoring) are both ways of accessing funds through unpaid invoices.
Accounts receivable financing (AR financing) is a way of obtaining a loan or line of credit based on unpaid invoices. The business still owns the invoices and is responsible for collecting payment.
Accounts receivable factoring (AR factoring) is selling unpaid invoices to a collection company. The factoring company owns the invoices and is responsible for collecting payment.
AR financing comes with less risk to the lender. With less risk comes larger financing amounts (generally 70% to 90% of the AR amount) and lower fees (1% to 5% of the AR amount).
Since factoring companies own the invoice, they take on more risk if it goes unpaid. The upfront payment is usually determined based on the age of the invoice and the customer’s likelihood to pay.
Both options should be considered if you’re looking to get funding from unpaid accounts receivable. Generally speaking, AR financing has lower costs but more responsibility for the business.
Common types of AR financing
There are four common types of AR financing for businesses to choose from.
Invoice discounting is when the business retains control over its receivables and borrows against them. The amount of funding is based on a percentage of the outstanding invoice amounts with a fee charged for each week the invoices are unpaid.
Invoice factoring is when the business sells its accounts receivable to a factoring company for payment now. The factoring company owns the invoices and is responsible for collecting payment. The amount of funding is a percentage of the outstanding amount based on the likelihood of collecting payment using factors like the age of the invoice and the customer’s payment history.
Asset-based lending (ABL) is when the business is given a loan with assets used as collateral. While the assets don’t necessarily need to be outstanding invoices, they’re an option. The amount of funding may be determined independently of the value of the invoices used as collateral depending on the business’s creditworthiness.
Purchase order financing is used by businesses to help fulfill large orders with upfront costs. The lender grants funds to cover the costs with payment being rendered after the order is completed. A lien (legal claim to the asset) is placed on the accounts receivable of the order.
Benefits of accounts receivable financing for companies
Accounts receivable financing can be a solution for problems both big and small. Look to leverage it for some of these benefits.
Controlling cash flow
Accounts receivable financing gives businesses the opportunity to generate cash flow when they need it. Rather than waiting on payments to come in, invoices can be quickly turned to cash.
This is especially helpful for businesses that have high costs of fulfillment for the goods or services they sell. If you need money to cover costs of fulfillment now and generate more revenue, you can without taking out a loan.
Speeding up payment
Depending on your net terms, you may not receive payment weeks or even months out from a sale. That timeline hampers your ability to quickly turn sales into investment in the business.
Even if it’s a difference of one to two weeks, AR financing helps you define the timeline you’re paid on and get that cash injection.
Access to capital independent of credit
For early stage businesses without an established credit history, it can be difficult to access capital. If they’re eligible for a loan, the lender will likely charge an expensive premium in the form of high interest rates.
Accounts receivable financing allows businesses with no or poor credit history can leverage their accounts receivable for short-term access to capital.
Drawbacks of accounts receivable financing
Businesses shouldn’t jump into accounts receivable financing without knowing some of its risks. Be mindful of these drawbacks before committing to the process.
Unpredictable costs
When a business applies for a loan, they know exactly how much they’ll be paying in interest as it’ll be documented in the loan agreement and amortization table. With AR financing, the costs are determined by when the customer pays.
Say you’ve financed an invoice worth $1,000. You’re paid 80% of the invoice ($800) and the lender will charge a fee of 3% of the invoice amount per week without payment.
Each week, the financing is costing you $24. If that customer takes a month to pay, you’re paying $96 in fees. For this reason, it’s best to use AR financing on invoices from customers with a solid payment history.
Impacts on customer relationships
In the case of invoice factoring, the factoring company will handle all communications with your customer. You don’t know how aggressive they’ll be or how frequently they’ll be reaching out.
There is the potential of souring your relationship with your customer. They may not like how the collections process is handled or that you looked for a third party to collect payment to begin with.
If you choose to use invoice factoring, consider how the customer may react to the process.
Dependent on the quality of your invoices
Accounts receivable financing isn’t a sure thing because you have unpaid invoices. The lending company will complete a vetting process by looking at how long the invoice has gone unpaid and the customer’s payment history.
It’s natural to get excited about turning unpaid invoices into cash, but it’s not a guarantee. And if you finance an invoice that goes unpaid, those costs build up.
Before you use accounts receivable financing, consider how likely your customer is to pay and on what timeline to estimate costs. The lending company will be looking at the exact same factors.
What to consider before using receivable financing
Accounts receivable financing is a fantastic tool to keep in your belt—a time may come when it helps you out of a jam. But that doesn’t mean it’s for everyone.
Before you turn to accounts receivable financing, consider these four questions:
- How much are you willing to pay for cash now? You may be able to find financing with lower costs so you aren’t giving up as much of your hard-earned sales revenue.
- Do you need a short-term or long-term solution? Rather than frequently using accounts receivable financing, you could try finding a line of credit that gives you access to cash when you need it.
- How reliable are your customers at making payments? The longer the invoice goes unpaid, the more accounts receivable financing is going to cost you.
- Can you shorten payment times in other ways? Consider changing your payment terms to shorten the window for your customers.
Accounts receivable financing best practices
Once you’ve chosen to pursue accounts receivable financing, there’s still work to be done. Follow these best practices to keep costs in check and get the most from your financing:
- Choose invoices with a high likelihood of payment: Fees typically accrue on a weekly basis. Know what you’re willing to pay for financing and establish a timeframe you expect payment on. If those don’t align, you should consider other options before committing.
- Don’t stop pursuing payment: The cash is in your hands now, but there’s still a debt to be paid. Keep following up with your customers with payment reminders (or use automated reminders to keep it hands-free).
- Consider all the options: Whether it’s financing or factoring, different options suit different situations. It might be worth taking a lower payout of factoring if it means you don’t have to pursue payment yourself. But consider the potential impact of factoring on the customer relationship.
- Analyze the impact: If you’re regularly using accounts receivable financing, you should always be checking in on how much it’s costing you once it’s paid off. Understanding the costs of accounts receivable financing helps you compare it against other lending options.
Example of AR financing
A home renovation company regularly takes on projects where they bill half of the project once the terms are accepted and the other half once the project is done.
The renovation company is responsible for covering all project costs and is reimbursed for some of the expenses on the second payment after the project is completed.
Because of their billing policy, they’ve found themselves having to get scrappy to cover project costs while waiting for the payment from their last project to clear. Since payment times are made up to two months after billing, they turn to accounts receivable financing to fast-track payments and speed up cash flow.
They billed $60,000 for their latest project: $30,000 paid upfront and $30,000 once the project is done. Over the course of the project, they accrued $20,000 in reimbursable expenses for a final billed amount of $50,000.
An accounts receivable financing company is offering them 80% of the invoice amount ($40,000) with a 3% weekly fee based on the borrowed amount.
After six weeks, they collect the payment of $50,000. The total fees are:
Total Fees = Weeks x (Fee Rate x Borrowed Amount)
Total Fees = 6 x (0.03 x $40,000)
Total Fees = 6 x $1,200
Total Fees = $7,200
The renovation company pays back the lender $47,200—the $40,000 originally borrowed and $7,200 in fees. They get to keep the extra $2,800 from the $50,000 payment for themselves.
Why invoice management matters for accounts receivable
Once you take on accounts receivable financing, you need to be extra diligent about tracking invoice payments and sending payment reminders.
Having an efficient accounts receivable process helps keep your financing fees in check. With BILL, you can save time by automating your accounts receivable process. Track outstanding payments with ease and send automated reminders to your customers. On average, BILL customers get paid two times faster.
Learn how to put your accounts receivable on autopilot with a guided demo.
FAQ
What are the requirements for accounts receivable?
The requirements for AR financing aren’t as strict as traditional lending. The main requirement is that the business has outstanding accounts receivable invoices from customers who are likely to pay.
What are the costs of AR financing?
The costs of AR financing depend on the fee percentage and the amount of weeks the payment goes uncollected. Generally speaking, fees will range from 1% to 5% of the borrowed amount for each week the amount goes unpaid.
The fees do not compound so it will be the same fee amount each week of borrowing. On a $1,000 invoice with a 3% fee, each week accrue $30 in fees.
What type of business should use AR financing?
AR financing is best suited for businesses that are billing large amounts with long payment terms and need to speed up their cash flow. For example, a manufacturer that needs to cover material costs to fulfill orders could use AR financing to generate the cash flow needed to fulfill more orders.
Similarly, retail businesses that need to pay for the goods they sell upfront could leverage AR financing to fulfill the same need.
Ultimately, any business with outstanding invoices can consider AR financing, but should consider the costs before committing.
Is AR financing risky?
AR financing is risky, but the business has the ability to control the amount of risk it takes on.
The biggest risk is that the invoice you’re financing goes unpaid for a long period of time and the fees keep racking up. If the customer goes delinquent, you still have a debt to pay without the cash to cover it.
Before using AR financing, consider which invoices have a high likelihood to get paid. It’s the invoices of the most reliable customers that are best suited for financing.
If you don’t want the risk of a payment going uncollected, consider AR factoring. Since the factoring company pays you upfront to own the invoice, you could be unaffected by an uncollected payment. Just make sure you’re not choosing factoring with recourse where the business must buy back the invoice if the factoring company can’t collect.
