What to know about accounts receivable financing

As every business owner knows, unexpected cash flow problems can spring up any time. However, the uncertain economy is exacerbating the potential for cash-flow disruption as more clients move to conserve cash by paying invoices later. If you have too many of these late invoices, it can seriously harm your cash flow situation.

Common financing options meant to provide businesses with capital, such as bank loans, can take too long to address the urgency of an immediate cash crunch. An alternative is accounts receivable financing, which can be a sound option when you need funding quickly to cover short-term expenses or fix cash flow gaps.

What is accounts receivable financing?

AR financing is a cash advance that business owners can receive on their outstanding customer invoices. With AR financing, also known as invoice financing, this capital is secured by the business’s unpaid invoices.

The lender advances the business a percentage of the value of their receivables, usually from 80% to 90%. Once the invoice is paid by your client, you receive the remaining portion, minus the lender’s fees. These fees can vary from 1% to 5% based on the invoice amount, the customer’s creditworthiness and sales volume.

In short, this type of loan lets you convert your AR into immediate cash, an effective tool to preserve growth while avoiding cash flow issues.

What differentiates AR financing from a traditional business loan is that unpaid invoices act as collateral for the cash advance — you are borrowing against money already promised to your business. You still own the unpaid invoices and remain responsible for collecting payment on them.

An example of how AR financing works

Let’s say you decide to finance a $25,000 invoice with a 60-day repayment term, and you’re approved by a lender for an 80% advance, or $20,000.

After receiving the $20,000 in financing, you use it to pay for business expenses. During the interval until your client pays the invoice, you are charged a 3% fee for every week that passes.

Assume your customer pays their invoice after four weeks. You owe the lender 3% ($750) of the total invoice amount of $25,000 for each week, or $3,000.

You must repay the lender the original advance amount of $20,000 plus fees of $3,000, or $23,000.

A second type of AR financing: AR factoring

In addition to invoice financing, accounts receivable financing can be structured as AR factoring or invoice factoring.

With AR factoring, you sell your business’s outstanding invoices to a factoring lender in exchange for a cash advance. The lender collects those invoice payments directly from clients, whereas with invoice financing, you’re still responsible for collecting payments.

When clients pay, you receive the invoice balance from the factoring lender, minus the factoring fee.

When to consider AR financing

According to the AP Automation Tracker, a project of PYMNTS and Beanworks conducted in 2022, some 49% of invoices generated by companies in the U.S. end up being past due.

It goes without saying that unpaid accounts can quickly devastate cash flow. Without reserves, you may struggle to pay vendors, taxes and employees or to cover overhead needed to run the business. So how do you decide whether AR financing is your best route?

AR financing is best suited to cases where the business:

• Has an immediate cash flow shortfall (30-90 days).

• Needs to expand and make improvements.

• Requires assistance with daily expenses.

• Needs cash on hand for new opportunities.

Pros and cons of AR financing

AR financing can be an excellent stop-gap measure for the right small business owner at the right time, but you need to be familiar with both its pros and the cons.

Pros

• You receive funding fast.

• You maintain control of your business’s invoices (with AR financing only).

• Business credit isn’t a deciding factor because invoices are collateral (AR financing only).

• You may see improved cash flow to the extent sales can be converted to cash faster.

Cons

• The company that buys your accounts receivable may demand a higher fee than other financing options. Depending on the customer’s credit score, average invoice amount and your industry, fees may range up to 5%.

• Invoice factoring represents a loss of control of the sensitive collections process to the factoring company, which could affect customer experience.

• With invoice financing, your business is still responsible for collecting the funds.

Takeaway

Before deciding whether to employ AR financing, consider the cost of financing relative to gain and the restrictions it could impose. Invoice financing can be a good choice for businesses with a poor credit history, but it gets very costly if clients don’t pay their bills on time. Invoice factoring may appeal most to those business owners who would like the ability to outsource the administrative burden of collection.