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Accounts Receivable Financing: Pros and Cons


Accounts Receivable Financing

Are you thinking about using accounts receivable funding for your business? As a small business owner, you likely know how hard it can be to get working capital to finance the growth of your business or pay the bills during occasional cash flow shortages. Many small businesses might encounter situations where traditional small business financing such as loans and lines of credit will be unavailable or insufficient. At times like these, some business owners use a different option to finance their business, which is known as “accounts receivable financing” or a “business factoring loan.”

There are several reasons why accounts receivable financing is becoming more popular as a business finance tool.

First, let’s answer the question, “what is accounts receivable financing”. Factoring is one of the oldest forms of commercial finance. (Accounts receivable financing has also been referred to as accounts receivable factoring or accounts receivable funding.) Accounts receivable financing is a process where businesses sell their outstanding invoices or receivables at a discount to a specialized finance or factoring company (usually called “the factor”) that will assume the risk on the receivables and in return will provide a quick influx of cash into your business. Instead of getting paid the full value of the invoice, your business gets an immediate cash payment by selling the rights to be paid by the person or company that you originally invoiced.

Accounts receivable financing works in a way that is somewhat similar to selling debt to a collection agency – your business gives up the right to get paid by your original customer (and also gets to stop spending time and money on pursuing the customer for payment), and in exchange the factoring company gives you an immediate cash payment and takes the invoice off of your “to do” list. Your customer still owes the amount due on the invoice, but now they have to pay the factoring company instead of paying your business.

The amount of value assigned to the account will depend on the “age” of a receivable. An invoice that is current will be worth more money to the factoring company than an invoice that is a month or two past due. Accounts receivable that are more than 90 days old are typically not financed, because these past due invoices present too high of a risk to the factoring company – the old invoices are already “late” which means that the factoring company might not get paid.

To better understand factoring, let’s put some numbers in an example. Suppose for a moment that your small business has $100,000 in receivables. If you decide to use receivables financing by working with a factor, the factor will advance funds to you at a certain percentage of the total amount of your outstanding receivables. This amount often ranges from 75 to 80 percent, and is based on a variety of factors including the age of a receivable (as discussed earlier) and the quality of the receivables. Basically, the factor evaluates how likely your customers are to pay their bills. For example, if you have big corporate customers with good credit like Costco or Walmart, then the percentage of advance funds that the factor gives you for your receivables will be higher. (For example, some accounts receivable financing programs might give you an advance of 90 percent of your receivables balance.) If your customers are mostly small businesses or consumers, the percentage of advance funds might be lower, since these receivables are often seen as “lower quality” in terms of likelihood of receiving prompt payment. The factor then assumes the risk of getting paid for your receivables, and once the receivables are paid off, you will get the difference between the face amount of your invoices and the amount that the factor kept in reserve (that 10-25 percent of your total receivables), minus the fee for the factoring company.

While accounts receivable funding may be a new concept to you, business factoring loans are one of the longest-standing forms of business funding. Some businesses may benefit more than others by choosing to work with a factoring company, while others may be better off seeking other funding options. Like any form of business finance, it’s important to consider the pros and cons and make sure it’s the right fit for your business needs.

Pros of Accounts Receivable Financing

There are many benefits of receivables financing for businesses of all sizes in a variety of financial situations.

  • Fast Cash
    Your company may need immediate cash for a variety of reasons such as buying raw materials, buying inventory, doing renovations or making payroll. Of course, cash usually comes from customers who pay for your products or services. However, if customers are slow to pay their bills, your business might need to look for other ways to cover your expenses during a cash flow crunch. So if raising cash is an immediate need and you are having difficulty getting sufficient funds through other means like a bank loan or line of credit, accounts receivable financing can be an effective option. With accounts receivable financing, you can often receive cash within 5-to-10 days, and sometimes even faster, within 1-to-2 days.
  • Freed Up Working Capital
    If you run a retail business, your business likely has the majority of its capital tied up in your inventory. Accounts receivable funding can quickly free up some working capital, so you can use it to buy more inventory and grow your business. You don’t have to worry about missing a great deal on inventory if you have cash ready and waiting. Or you can use the instant cash to generate growth by hiring another salesperson who will bring in more business, or spending money on marketing to reach new customers, or buying a piece of equipment that will accelerate production. Instead of watching your capital sit idle on your balance sheet (in the form of unpaid invoices), accounts receivable financing can help free up this money and put it to work in growing your business.
  • Time Saved
    Accounts receivable financing can save you time and effort that would otherwise be spent on collecting money due from customers. Since most factoring arrangements will include the process of obtaining the money from customers, it’s one less thing you will have to worry about. Outsourcing your accounts receivable management to another company frees up your resources to focus on other more productive (and lucrative) activities such as selling. The factor will take care of getting the money, and the factoring company is on your side – after all, they definitely want to get paid. And you can use the time and money normally spent on collections and redirect it to making money and building your business! Sales, marketing and client development can all use your excess time and money. Using accounts receivable financing is a way to take some stressful items off of your “to do” list.
  • No Collateral Required
    A business factoring loan is a type of unsecured financing, so it won’t require collateral from your personal or business assets. Most business owners prefer to avoid putting their house, car, inventory or place of business as collateral for a loan. These assets are critically important to your success and quality of life, and it’s often best to avoid putting them at risk just to get a loan. While most traditional lending options will require some sort of collateral from you, accounts receivable funding will not. So keep the things that matter most, and get your much-needed infusion of cash from a funding source that doesn’t require them.
  • Retained Ownership of Your Business
    Another option for business finance is to raise capital by selling equity in your business. But many small business owners do not want to give up ownership (even partial ownership) of their business. Often small businesses and startups have to rely heavily on outside investors in order to keep running and growing. While this might seem like a good idea, it does force you to give up a percentage of your company ownership each time you go back for more funding. Accounts receivable financing is not like this. With receivables financing, you will retain sole control of your company while still getting the capital you need to operate.

Cons of Accounts Receivable Financing

While there are a large number of benefits to factoring your accounts receivable, there are also some potential drawbacks to using this method to finance your business. Make sure that you educate yourself about the potential downsides and risks of accounts receivable financing before committing your business to this type of financing.

  • Stigma
    Some business owners feel like there is a certain “stigma” that goes along with accounts receivable financing. The stigma is not related to factoring being perceived as “unfair,” because business factoring loans are a long-standing viable and legal financing option. The stigma comes from the sense that some people might think that if your business is relying on receivables financing, this is a “bad sign” that your company is struggling. There might also be some confusion for your customers – because if you sign up for accounts receivable financing, your customers will be notified when the factoring company takes over your receivables. When customers hear that they will no longer be paying you, but will instead be paying their bills to a factoring company, it might make them think (unfairly) that your company is having cash flow problems or is at risk of going out of business. So be sure to communicate upfront and be proactive with your customers to explain the situation and assuage any doubts or fears that they might have. Reassure your customers that you are in business for the long run.
  • Loss of Control
    While receivables financing does not affect the ownership of your business, you may have to give up some control of certain business processes. For example, the factoring company could tell you that you have to stop doing business with a particular customer or group of customers because of a poor credit history or rating.
  • Cost
    As a savvy business owner, you know that financing of any type is never free. While it may be necessary to have immediate access to cash, obtaining cash using receivables financing may come at a higher price than loans. Factoring companies usually keep between one and four percent of a receivable as their fee. Additionally, they charge interest on the cash advance, typically at least the prime rate plus a percentage or two. While the costs of accounts receivable financing might not seem like very much on a month-to-month basis, if you look at the full picture of what you pay for receivables financing, it can add up to more than 30 percent in annual interest.
  • Contract Length
    If you decide that accounts receivable financing is for you, you will enter into a contract with a factoring company. Unfortunately, the length of your contract may not be as short as you would like. Some of the receivables financing agreements can be quite lengthy—up to two or three years in some cases—and that’s not always the best thing for businesses. But the market has been changing and shorter contracts are now becoming more available and acceptable. Make sure you negotiate the contract length with your factoring company – you might only need immediate cash or short-term financing, and being locked into a long-term contract might not be the best fit for your overall needs.
  • Rate is Based on Your Clients
    Receivables financing is unique because instead of being judged based on your own business’ credit, your access to a business factoring loan is based on your clients’ credit. Like any business, you have your share of good and bad clients. Not all of your clients can be like Walmart, with deep pockets and reliable repayment. If your business has an unfortunate number of slow-paying clients or has some clients with less than stellar credit, keep in mind that these aspects of your client base can affect the discount rate that you pay to the factoring company. If the factoring company finds that your clients are unreliable or do not meet their standards, you may also receive a lower percentage of cash up front. Your clients’ poor creditworthiness or uncertain payment history might even cause you and your business to be ineligible for receivables financing.
  • Factoring Companies are Not Collection Agencies
    Receivables financing works in some ways that are similar to selling debt to a collection agency, but it’s not exactly the same. Factoring companies do not act as collection agencies. This means that if one of your clients does not pay their outstanding balance by a predetermined date or if they fail to pay altogether, this will likely increase the total cost you owe to the factoring company, in addition to adding to your current workload. Before you consider a business factoring loan as an option for a cash advance, make sure you are aware of your clients’ payment history. Although factoring services can be beneficial for various businesses, it may not be the best decision for you if you cannot rely on your clients to pay their bills.

All companies—big and small—need access to credit in order to support their inventory, meet payroll and pay their day to day operating expenses. And all companies will have times where they need money quickly. If your business is having difficulty getting approved for traditional styles of loans or lines of credit, accounts receivable financing might be an option that will suit your business needs. However, it’s important to be aware of the various costs, risks and possible downsides of any financing option before you commit to that course of action for your business. Educating yourself about the pros and cons of receivables financing will help you decide whether this is the right choice for your business to pursue.

What are your biggest concerns about taking out a business factoring loan? Share your thoughts with us in the comment section below.

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Ben Gran

Ben Gran is a freelance writer from Des Moines, Iowa. Ben has written for Fortune 500 companies, the Governor of Iowa (who now serves as U.S. Secretary of Agriculture), the U.S. Secretary of the Navy, and many corporate clients. He writes about entrepreneurship, technology, food and other areas of great personal interest.