Accounts receivable (A/R) financing is a practical solution for businesses to convert outstanding invoices into immediate cash. This type of financing can take the form of factoring or borrowing against receivables and is especially beneficial for businesses with limited credit histories that may not qualify for traditional bank financing. Some financing companies even blend factoring with lending, offering a hybrid approach.
What is Accounts Receivable Financing?
Accounts receivable financing, also referred to as invoice financing, involves either borrowing against outstanding invoices or selling them at a small discount to a factoring company. This approach is ideal for businesses that need quick access to funds for upfront payments, rapid expansion, or managing projects with longer client payment terms.
Unlike traditional loans, accounts receivable factoring relies on the creditworthiness of your clients rather than your own. This makes it particularly valuable for newer companies working with established clients.
How Does Factoring Work?
Factoring follows a straightforward process:
- The business provides the factoring company with a copy of the invoice sent to the client.
- The factor verifies the invoice and runs a credit check on the client.
- The factor advances a percentage of the invoice amount (usually 70%-96%) and holds the remainder as reserve.
- Once the invoice is paid, the reserve is released, minus the discount rate and any additional fees.
Types of Factoring
There are two primary types of factoring:
- Recourse Factoring: The business must replace unpaid invoices or repay the factor if the client doesn’t pay within a specified timeframe. This option typically has lower fees and is ideal for businesses with reliable clients.
- Non-Recourse Factoring: The factor assumes the credit risk and absorbs losses if the client doesn’t pay. While this option offers more security, it comes with higher fees.
How Much Does Factoring Cost?
The cost of factoring depends on the arrangement with the factor. Advance rates typically range from 70% to 96%, with the remainder held as a reserve to cover disputes or partial payments. Fees vary based on factors like industry, client creditworthiness, invoice volume, and dollar amounts.
Example:
- Invoice Amount: $10,000
- Advance Rate: 85% ($8,500 upfront)
- Reserve: 15% ($1,500 held)
- Discount Rate: 2% ($200)
- Other Fees: $100 due diligence fee
- Arrangement: Full recourse after 90 days
In this scenario, the business pays a one-time fee of $300, and the invoice is charged back if the client doesn’t pay within three months.
Types of Borrowing Against Receivables
Borrowing against receivables can take the form of loans or credit lines. In these arrangements, lenders establish a borrowing base, which is the maximum amount the business can borrow, calculated by discounting the value of liquid assets like receivables and inventory.
- Accounts Receivable: Higher advance rates (up to 85%).
- Inventory: Lower advance rates, typically 50%-100% for raw materials or finished goods, while ineligible items like work-in-progress or obsolete inventory are excluded.
Example of Borrowing Base Calculation:
| Month | Eligible A/R | Loan Availability (85%) | Eligible Inventory | Inventory Loan Availability | Borrowing Base |
|---|---|---|---|---|---|
| April | $100,000 | $85,000 | $30,000 | $15,000 | $100,000 |
| May | $110,000 | $93,500 | $45,000 | $22,500 | $116,000 |
| June | $120,000 | $102,000 | $60,000 | $30,000 | $132,000 |
In this example, the lender agrees to a $150,000 revolving credit line, but the actual amount available each month is determined by the borrowing base.
Other Types of Accounts Receivable Financing
Some financing companies offer hybrid solutions that combine factoring and lending. These arrangements may involve purchasing invoices without an expiration date, functioning similarly to a line of credit.
Example of a Hybrid Transaction:
- Invoice Amount: $100,000
- Advance Rate: 85% ($85,000 upfront)
- Reserve: 15% ($15,000 held)
- Discount Rate: 5% monthly ($5,000 until collected)
- Arrangement: Recourse with no maturity date
In this case, the business pays $5,000 per month until the invoice is collected. Upon collection, the reserve balance is returned.
Advantages of Accounts Receivable Factoring Compared with Loans
- Speed: Factoring requires minimal paperwork and provides funding within 24-48 hours.
- Additional Services: Factors offer credit checks, invoice processing, and collections for factored invoices.
- Less Emphasis on Credit History: Startups with limited credit histories can qualify, provided they have invoices from creditworthy clients.
- No Debt: Factoring doesn’t increase leverage, unlike loans that require repayment over several years.
- Flexibility: No restrictions on how funds are used, unlike loans with specific usage covenants.
Conclusion
Accounts receivable financing is a versatile solution for businesses facing cash flow challenges. Whether through factoring or borrowing against receivables, companies can access working capital quickly, often within two days. With no long-term commitments or restrictions on fund usage, factoring is a creative and flexible alternative to traditional bank loans.
The global factoring market is valued at approximately $3 trillion, with $120 billion in invoices factored annually in the U.S. alone. Contact Business Factors & Finance today to explore how accounts receivable financing can support your business’s growth and operational needs.