Accounts Receivable Financing: What is It and When can Small Businesses Use It

For small business owners, unpaid invoices remain a major factor in holding back growth. In fact, Fundbox found that if all late invoices were paid at once, small business owners could hire 2.1 million incremental employees and pay themselves an average of $31k more incrementally.

Poor cash flow can also impact the overall viability of your business. According to a study from US Bank, 82 percent of business failures can be traced back to problems with cash flow.

Unfortunately, you’re probably not going to receive all of those payments at once or prevent late payments altogether. But there is another solution that could help you with cash flow issues and get the money from those delayed invoice payments a bit earlier. It’s called invoice financing, or accounts receivable financing. Basically, it’s a type of loan you can get based on outstanding receivables.

Say you’re coming up to the end of the month and you’re a little short on cash. You have several invoices sent out to clients, but there’s no guarantee that they’ll pay by the time your next bill is due. The situation isn’t dire enough for you to need a fully fledged small business loan — you just need the money that you should receive when those outstanding invoices are paid.

In that case, you can reach out to a company that provides accounts receivable financing or factoring. If the situation above sounds familiar to you, read on for more details about this type of financing and how it could potentially be an option for your business.

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What is Accounts Receivable Financing?

Accounts receivable financing involves borrowing against your receivables or selling your receivables to a company that will pay you an amount equivalent to the invoice amount due you, less a discount.  The amount of the discount varies depending on the size of the transaction, the extent of risk that the financing company (sometimes called a “factor”) has to take to collect the amount due, and other matters.  You’d get more for an invoice payable by a blue chip company that’s due soon versus one that’s, say, 90 days past due from a weaker payor.

Factoring has been around at least 500 years, says Dan Casey of AccountsReceivableFinancing.com.  He notes that it  involves the:

“… process of selling your rights to collect an invoice.  The factor/invoice buyer pays a high percentage of the invoice face value day one.  Upon collection, the factor funds the balance of the invoice value less their fees for service. “

Here is a breakdown of different accounts receivable financing types:

So with these types of services, you can either borrow against the money you expect to come in soon, or sell the invoice itself at a discount.  The net effect in either case is that you get a lot of money a lot sooner. You can see other benefits and drawbacks in the chart above.

Benefits of Accounts Receivable Financing

The primary benefit to these financing services is to help small businesses get cash quickly.

It’s particularly useful for businesses that get paid large invoices by clients that may pay slow for one reason or another (such as large corporate clients, or when part of a large multi-phase government contract).  Yet, in the interim that small business still has a payroll to meet — putting the business in a cash flow bind.

Accounts receivable financing can also help free up working capital. Because so many businesses have funds tied up in inventory, getting paid for invoices quickly is paramount.  Getting financing takes that worry out of the equation for small businesses.

Factoring, where you actually sell the invoice outright and the factor takes over collection, can take away the headache of chasing down payments from clients. That alone can save a small business time and money in the form of internal staff resources dedicated to follow-up and collection.

What Are the Costs of Accounts Receivable Financing and Factoring

Just like any other type of financing or loan, you will pay for the privilege of getting access to cash quickly. Casey says at his company, invoice financing fees can vary from 1% to 3% per month. The rate you’ll pay depends on the size of the transaction, your monthly dollar volume and your credit worthiness. The fees will also depend on whether you’re getting factoring financing or accounts receivable financing.

Is Accounts Receivable Financing Right for Your Business?

Accounts receivable financing companies often specialize in a particular industry or type of transaction, e.g., staffing services industries or government contracts.  When looking for such financing, check their website or ask if they handle transactions in your industry or of your type.

Consider your reasons for needing quick financing. Is it a temporary problem?  If not, it might be indicative of something bigger that needs to be addressed. Accounts receivable financing is not designed to buy time to hold off the inevitable.

How much are you willing to pay for the privilege of getting access to money faster?  In essence, accounts receivable financing is like dropping your prices. On the other hand, it might be well worth it if it keeps your cash flow steady and uninterrupted — the alternatives (drawing on expensive credit cards or incurring late charges) could be more expensive.  You really have to look at the big picture and the full impact. Speak to your accountant to understand the overall financial impact on your company.

Image: DepositPhotos.com

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