Do you know anything about accounts receivable financing? What is it and how does it work? What are the main types of this financing? What are some of the factors that affect the quality of receivables? Are there any advantages and disadvantages associated with this type of funding?
What is account receivable financing?
This is a source of short-term funding that a business can get based on their account’s receivables. Account receivables are assets equivalent to the outstanding balance of invoices yet to be paid by customers. They are classified as an asset in the company’s balance sheet. This type of funding is available for businesses that require financing but are not eligible for traditional lenders. Many businesses require additional cash flow to support:
- Business growth.
- New opportunities.
- Solve short-term cash needs.
- Seasonal demands.
How it works
Companies may sell their products or services to their customers by giving them credit. This is beneficial to the customer but can affect the cash flow of the business. Accounts receivable financing helps a struggling business to get funding hence, avoiding the collapse of the business.
- The borrower sells the outstanding invoices at a discount to the financing company.
- The financing company assumes the risk on the receivables and cash payment is made to the borrower.
- Accounts receivable loans.
The accounts receivable is used as collateral by the borrower to ask for a loan from a bank. The better the quality of receivables, the higher the fraction loaned. The borrower owns the receivables and is supposed to collect from their debtors. To avoid a misunderstanding with the financing company, ensure you have a good relationship with your debtors and they are sure to pay.
- Asset-backed security.
It is a form of financing available to large organizations. They pay their investors by deriving their cash flow from their assets. A special purpose vehicle is a device that holds the receivables, collects the payments, and pays the investors. This is a good way for large companies to securitize their receivables and get loans. The quality and diversification level of the company’s receivables determines the credit rating.
This is a common source of financing for small businesses. The borrower sells their account receivables to the factoring company at a discount. The borrower is not responsible for debt collection but, the factoring company is. Interest expense and several fees are required hence expensive.
What factors affect the quality of receivables?
- Duration of receivables.
This is the number of days that the receivables are outstanding. Long-duration receivables are of low quality because the probability of defaulting goes high. The cost of financing is lower if the duration is short.
- Quality of documentation.
Good quality documentation clarifies the terms of the contract. In case the loan has defaulted, it provides the basis for legal recourse. Good and clear documentation improves the quality of the receivables.
- The creditworthiness of the debtor.
If the debtor has a poor credit rating, the quality of receivables is greatly reduced and the cost of borrowing increases.
- Fast access.
This financing allows you to turn credit sales or invoices immediately into cash. This protects your business from a financial blow caused by unexpected expenses or late payments.
2. Friendly to small businesses.
It takes a long time to get a loan from a bank since they have to verify if your company is creditworthy. Accounts receivable financing does not require collateral and it takes a few hours or days to be approved for the funding.
3. Keep your equity.
Some financing companies provide a large amount of money to help your business grow but want a substantial stake in your company as insurance of payment. The ownership of your business remains 100 percent yours since accounts receivable funding does not require equity in your company.
- Higher cost.
The loan rates are higher compared to other business loans. The total amount of money paid increases if the payment is not made on time.
2. Lengthy contracts.
Some agreements are long while others are short. It is important to negotiate the length of the contract that favors you.
3. If the customers fail to pay their invoices, you will have to make a repayment on their behalf.
Accounts receivable financing is when your business is given a loan based on their account receivable. This type of financing enables you to get immediate financial support, boost the financial profile and credit rating. The main types of this funding are accounts receivable loans, factoring, and asset-backed security. The quality of receivables determines the fraction of the loan you can receive, and some factors that affect the quality of receivables have been mentioned. This type of funding has its upsides and downsides.