How Accounts Receivable Financing Works

Accounts receivable financing gives a business the opportunity for short term funding that it can draw from its receivables. Receivables are invoices for purchases for which the business has not yet received payment.

In business, cash is the king. To avoid cash flow issues, a business has several options to consider. One option is to sell its invoices to an invoice factoring company (a financial company). The factoring company is an intermediary company that specializes in trade finance and provides several financing solutions.

The company that needs financing then applies to the factoring company with the sample or original copies of the financing invoices. The factoring company checks the application and both parties will then agree on the terms and conditions of the financing. Some of the things that the factoring company will consider are:

  • The credit history of the debtor
  • The duration of the buyer/seller relationship

After both parties sign the agreement, the factoring company will pay the applicant 80% of the net worth of the debtors' amount. The factoring company pays the remaining 20%, minus a factoring fee, after the debtors have paid off the full amount in time.

Example Of Account Receivable Financing

A company is in the business of selling furniture to hotels, restaurants, and private individuals. The company receives a purchase order from a five-star hotel (the debtor), and they are willing to buy furniture worth $400,000.

The hotel needs the furniture right away, but they won't make the full payment immediately. They'll be able to pay the company over 4 months. The company accepts the terms and conditions for the transaction and deliver the furniture to the hotel. It then issues an invoice for $400,000 due in 4 months.

This type of agreement might not be good for business if other customers repeat these payment terms. The furniture company might run into cash flow shortages, and if they don't handle invoicing properly, it can jeopardize the company's ability to function well.

To avoid cash shortages, the furniture company approaches the factoring company and applies for accounts receivable financing. If the factory company approves the application, they will pay the furniture company an advance payment of $316,000, 80% of the total amount on the invoice. The factoring company will then pay the remaining $84,000, minus a factoring fee, to the furniture company when the debtor pays off the full amount in due time.

By doing this, the furniture company gets access to cash immediately, and it can quickly make a furniture sale. The hotel gets the furniture it needs and pays later while the factoring company profits from the factoring fee. This is a win-win for both the furniture company and the factoring company.

Types Of Accounts Receivable Financing

Account receivable financing can take various forms, but these are the three major types:

  1. Accounts Receivable Loans

Accounts receivable loans are short-term funding solutions. In this case, the borrower can use their accounts receivables as collateral in a bank. The bank will normally lend a fraction of 80% of the face value of the total receivables. Then the fraction to be paid depends on the quality of the receivables submitted to the bank.

The company approaching the bank for a loan still owns the receivables and is responsible for collecting them from their debtors. Businesses should only apply for account receivable loans if they are sure that their debtors will payback. Otherwise, this might cause some problems between the bank and the company.

2. Factoring

This is the most common form of accounts receivable financing for small businesses. In factoring, the borrower sells its receivables to a factoring institution. The quality of the receivables determines the amount the seller will get at the end of the transaction.

In this type of receivable financing, the factoring company is responsible for setting up the collection process. Factoring is usually more expensive than the other types of receivable financing, but it takes away the stress of getting the debtors to pay back what they owe.

3. Asset-Backed Securities

Big organizations normally use this type of financing. It is a fixed income instrument that makes payments to its investors by getting its cash flows from its assets. Mortgage-backed security that uses mortgages as their underlying assets is an example. The credit rating of the asset-backed securities depends on the quality and diversification level of the receivables.