Companies that offer unique payment terms to their customers may often experience cash flow issues. Since most of their capital gets tied up on their invoices, it can be challenging for them to meet their monthly payables or take advantage of a business opportunity as soon as it presents itself. Cash flow is the lifeline of any business, and without one, businesses could face closure.
Fortunately, accounts receivable loans allow businesses to advance the cash they need to keep their cash flow stable. This way, they won’t have to wait for their clients to pay them. If you’re considering accounts receivable financing for your business, we’ve gone ahead and outlined what you need to know about it.
What is an Accounts Receivable Loan, and How Does It Work?
Accounts receivable (A/R) loans, otherwise known as invoice financing, allow businesses to leverage their accounts receivables to accelerate cash flow. In invoice financing, the company can free up the cash tied to their invoices and use it towards any business initiative. It could be inventory, equipment repair or purchase, expansion, or day-to-day expenses.
In general, financing companies can provide as much as 60% to 90% of the invoices’ total value to companies. Depending on the agreement, the business can choose to have the financing company collect the customers’ payments. However, it would mean that the customers would be aware that the business is using invoice financing. For businesses that aren’t comfortable with this arrangement, they opt to retain control of their sales ledger, collect the payments themselves, and repay the invoice financing company once the customers pay their invoices.
Fees associated with invoice financing may also depend on the type of invoice financing the businesses made use of. In general, the invoice financing fees could range from 1% to 5% of the total amount of the invoices being financed.
What are the 3 Types of Accounts Receivable Financing
A/R loans can take on various forms. Here are three common types:
In traditional factoring, businesses sell their accounts receivables to a factoring company at a discount. The factor provides the cash upfront – usually 80% of the invoices’ total value – then takes over the company’s sales ledger. The factoring company will also be responsible for the payment collection from the business’ customers.
For example, if a business sells its invoices worth $100,000 at an 80% rate, it would receive $80,000 in funding. The company will submit its ledger to the factoring company, and customers will pay the factors directly. Once every outstanding invoice has been settled, the factor deducts the advanced amount ($80,000) plus the fees associated with the service (usually 3% to 4%). The factors then return the remaining balance to the company.
Selective Receivables Financing
As the name implies, selective receivables financing allows businesses to select which invoices they want to use to get funding. The biggest difference between selective financing and traditional factoring is that in selective financing, the companies receive funding equivalent to the accounts receivable’s total value.
Another benefit of selective receivables financing is that the financing doesn’t appear on the company’s balance sheet. In other words, it won’t affect the debt-to-income ratio of the company.
Asset-Based Lending (ABL)
Asset-based lending, or ABL for short, is probably the most complicated type of accounts receivable loan. The process of ABL uses a special purpose vehicle (SPV). This instrument holds the receivables, handles the collection, and passes them on to the investors or borrowers. The SPV serves as the middleman of the financing. The customers will also deposit their invoice payments in the SPVs.
Unlike other types of accounts receivable loans, the financing company would have to commit all of their accounts receivable to get funding. It also reflects on the companies’ balance sheets, and the fees may be more expensive than the other A/R financing options.
What Factor Can Affect the Quality of the Invoices
However, the terms would depend on the quality of the invoices that are being financed. The higher the quality of these accounts receivables, the higher the financing amount would be.
Let’s look at four factors that can affect the quality of the invoices:
One of the most critical considerations of invoice financing is the customer’s creditworthiness. Unlike banks or credit unions, invoice financing companies don’t take the business credit history as a major consideration for approval. Instead, they gauge the financing risk by looking at the clients’ (the business’ customers) creditworthiness.
If you’re considering accounts receivable loans to boost your cash flow, you must ensure that your clients are creditworthy. This way, you’ll have better chances of getting approved.
Invoice payment duration
Payment duration refers to the number of days given to the customers to settle their accounts. Invoices with payment terms of 90 days must be paid within that time frame. Otherwise, the lenders would consider it default. Depending on the agreement, the lender could charge the invoice back to you.
In general, the longer the duration for the invoices financing is, the lower its quality would be. This means that if you want to get a higher percentage of funding, submitting accounts receivables with a shorter payment period would be the most ideal.
Typically, the more invoices you submit to the company, the higher funding you’ll receive. This is because if you sell or use more invoices, the banks would also collect more in fees. Moreover, a larger volume of invoices would show the financing company that you have some skin in the game, giving them the impression that you’re fully committed to the financing.
Type of industry the business is in
The type of industry the business’ clients are in also matters because some industries are more volatile than others. For instance, construction companies are relatively volatile as their sales can easily be affected by weather conditions and natural calamities such as earthquakes. This makes them a high-risk borrower for the financing company.
To mitigate the risk, the financing company could either offer a lower percentage of funding or charge higher fees to businesses with these types of clients.
Final Thoughts on Accounts Receivable Loans
If your company is experiencing a cash crunch because of outstanding invoices, you can free up your capital through accounts receivable financing. Keep the information provided above in mind when considering accounts receivable financing for your business. If you can, talk to a financial expert to verify if it’s the right funding option for your business.