The Ins and Outs of Accounts Receivable Financing

Business owners and operators often ask: What is accounts receivable financing? Also known as AR financing, accounts receivable financing effectively allows companies to access additional payments and funds by borrowing against their outstanding invoices or selling these assets to third parties at a discounted rate. Using accounts receivable financing methods, your customers’ unpaid balances essentially become collateral for loans, or a liquid asset that is sold on to another vendor. Money provided through this financing method can be applied towards everyday operating expenses, large purchases, unexpected costs, and more. 

Accounts Receivable Financing Explained 

Before digging deeper, it helps to start with a simple accounts receivable definition. When you sell products or services to a client, an accounts receivable entry for the amount owed is recorded on your books, which customers are obligated to pay according to your billing terms. Your company’s accounts receivable are therefore basically liquid assets that amount to the total outstanding balances that you have billed to customers (but have yet to receive payment on) to date. 

For those wondering what is accounts receivable financing, by proxy, it allows you to borrow money and receive an advance from a lender against these outstanding invoices in certain circumstances. In other scenarios, it allows you to sell outstanding client balances that you’re owed for a fraction of their total amounts to another institution in exchange for up-front payment. 

Primary Types of Receivable Financing

Four methods of accounts receivable financing make it possible to secure funds more rapidly without having to wait for your customers to make invoice payments. You’ll want to run a financial analysis and do up-front research to determine which makes the most sense for your company. 

1. Asset-Based Lending: Mechanically, under asset-based lending methods, customer invoices function as collateral through which you secure a business loan or line of credit that provides cash for your business. You’ll pay interest on sums borrowed, which will be a percentage of your total accounts receivable amount.
2. Factoring: Alternately, you can engage in factoring, or the practice of selling your accounts receivable to another party at a discounted rate in exchange for a cash advance. Under this scenario, the purchasing party becomes responsible for collecting payment from the clients and is able to turn a profit upon receipt of these balances.
3. Invoice Discounting: As a third option, you might also engage in invoice discounting, whereby a lender provides a percentage of outstanding payments via a loan and the debt remains yours to collect. However, once the customer invoice is paid, balances must be repaid to the lender with fees and interest.
4. Supply Chain Finance: You may also have heard this term referred to as supplier finance or reverse factoring. It speaks to a scenario under which suppliers can get paid early by a buyer’s backing financial institution (with an invoice discount typically offered to the paying institution). Buyers then repay the party who fronted the balance – effectively allowing them to improve cash flow and lengthen the term of supplier payments that are owed. 

Mechanics of Receivables Financing 

Accounts receivable financing companies provide working capital and/or loans to firms looking to engage in factoring or asset-based lending. Here’s how AR financing works in general practice: 

1. Submit Your Application: Start by determining which invoices you’ll use for factoring or as loan collateral. To minimize risk, try to utilize invoices from reliable clients with a timely history of payment. Pick a factoring or asset-based lending partner and submit paperwork.
2. Receive Funding: If you’re engaging in factoring, you’ll receive your preset payment from another vendor. If you’ve opted for asset-based lending, you’ll typically receive a line of credit against which you can borrow as needed. A line of credit is generally extended in a fractional amount of total invoice values (typically 70-80%) up to 90% of total outstanding billed invoices.
3. Process Customer Payment: Under factoring scenarios, the party to whom you’ve sold the outstanding debt will collect any outstanding balances from customers. If you’re using asset-based lending methods of accounts receivable financing, you’ll retain ownership of the invoice and collect from clients directly.
4. Repay Accounts Receivable Financing Companies: Having collected from your customer, you’ll repay your line of credit or loan in addition to any fees or interest charges that have accrued. Should your customer pay your lender, your lender will forward on any remaining balances minus interest charges or fees that you’ve incurred. 

Businesses may typically turn to receivables financing as a means through which to secure immediate access to money without spending significant amounts of time working to secure a business loan or dealing with complicated financial applications. 

What Sets Apart Accounts Receivable Financing 

This method of business financing comes with myriad upsides and advantages attached. For instance, it allows companies to receive money faster, have more ready access to capital, and potentially tap another liquid asset as a source of loan collateral. It’s also a cost-effective way to secure financing with less restrictions or credit hassles. Depending on accounts receivable financing structures, arrangements may also not impact your debt-to-income ratio (helpful when seeking credit or borrowing options) and allow you to retain control of your receivable accounts. 

Advantages of Opting for Selective Receivables Financing 

Under asset-based lending methods, you have limited flexibility with regard to which receivables you can tap as collateral. Using factoring, you’ll give up control of your accounts, and may face higher fees and charges. The practice of selective receivables financing lets you decide which receivables should be subject to early payment – and lets you receive advanced payment on the total amount of the receivables. Rates may be lower for financing, and – depending on how account receivable financing companies structure programs – arrangements may not be counted as debts or impact your company’s access to further credit.

You can also elect when to participate in selective receivables financing (e.g. only in off-seasons or if an economic downturn hits) and leverage multiple lenders as sources of funding. Because you can turn to multiple funding sources, prices may often be better as well, due to the competitive nature of the marketplace. 

Integrating AR Finance Into Your Strategy 

Perhaps you’re looking to make a big purchase, need money to cover an unexpected expense, or simply wish to have added access to working capital for everyday operating needs. Under these circumstances, it may make sense to either selectively or widely embrace the practice of accounts receivable financing. Businesses may typically turn to receivables financing as a means through which to secure immediate access to money without spending significant amounts of time working to secure a business loan or dealing with complicated financial applications. It’s a common source of funding and borrowing against account collections that can be used selectively at times or throughout the entire year by companies of all sizes. 

Navigating the Landscape of Strategic Finance 

A popular choice of financing for many firms, accounts receivable financing may be right for you. But before signing on the dotted line, it’s important to do your research and homework first – and decide which of your customer receivables accounts may make sense to borrow against or sell, and when.

Looking for more insights into strategic financing options that can help you build and grow your business? Also be sure to check out 6 Tips for Small-Business Financing, which can also help you secure access to capital more rapidly. 

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