Accounts receivable (A/R) financing, also called invoice financing, involves the use of customer invoices as collateral to unlock cash tied up in unpaid invoices. This can be a great option for getting fast cash, for businesses that might lack other collateral or businesses lacking good credit.
Many businesses bill clients on 30, 60 or 90 day terms, meaning you have provided your services and incurred your costs, and now you have to wait on the cash for those services. To get that cash faster, companies can turn to accounts receivable financing. Accounts receivable financing is similar to invoice factoring, though they are not the same. More on that below.
Table of Contents
What is accounts receivable financing?
Accounts receivable financing, also called invoice financing or A/R financing, is a method of securing funding by using your unpaid invoices as collateral for a loan. The lender reviews the invoices and the business’s past collection history to determine how much it can lend. As the invoices are paid, the business will pay back the lender.
A/R financing can be used by companies of all sizes as an alternative to securing a typical business loan. Usually, a bank term loan with fixed payments is the less expensive option for a business making a significant purchase or funding a large project. However, A/R financing can be a smart solution for the temporary cash flow challenges all businesses face from time to time.
In addition to solving cash flow issues, A/R financing has other benefits. Compared to other loans, it will have fewer approval requirements. A/R financing will typically not require additional collateral or the business owner to have a good credit score.
A/R financing is also much faster to obtain than traditional bank loans or SBA loans. (For more on those, see Are SBA Loans Right for Your Business?)
How does accounts receivable financing work?
Once your business has delivered the goods or services to a customer and payment is due, it may invoice customers with payment terms, meaning customers may have 30 or 60 or 90 days to make payment. Those outstanding payments are considered the business’s “accounts receivable.” Lenders see those invoices as company’s assets, proof that the company has money that will come in at some point soon. Lenders will approve financing based on the total amount of the outstanding invoices your company submits as collateral.
Unlike a business term loan with substantial documentation requirements and a time- consuming approval process, accounts receivable (A/R) financing is a much simpler process. A/R financing involves a business committing some or all of its unpaid invoices to an A/R lender for early payment in return for a fee—in essence, the invoices act as collateral for the A/R loan or line of credit.
Who is responsible for collecting unpaid invoices?
With A/R financing, your business continues to be responsible for collecting all unpaid invoices. The lender does not handle any collections, and thus your clients do not have to know you have obtained financing using the invoices.
With invoice factoring, the financing company actually purchases your unpaid invoices, and usually that company does notify the customers and collects payments directly from those customers. This is one reason some businesses prefer to use A/R (invoice) financing – it avoids customers knowing they are borrowing money.
What are the steps to find the best A/R financing?
As you research accounts receivable financing companies, you will want to find out how much the company typically funds per invoice. This is most often from 70%-85% of the invoice’s total. Also investigate how fast you can be approved – this can often be within 24 hours.
Ideally, work with a financing company that allows most or all of the application to be done online. If you aren’t already familiar with a number of lenders, it can very helpful to work with a lending platform like Everfund that can connect you with many different options.
Be sure to understand the fees involved and the timeline of the financing contract before you commit. For example, some lenders expect full repayment within a specific period, such as 12 or 24 weeks.
Finally, along with the application, you will decide which invoices to submit. Some A/R companies ask to retrieve the information directly from your accounting/invoicing program so the data is easily accessible. The financing company will review the invoices to decide which they can include for purposes of the financing. Some invoices, particularly very old ones, may not be able to be included.
How is A/R financing paid back?
Most A/R financing lenders will require weekly or monthly payments, often including a fee, until you have paid the amount borrowed in full. In the case of invoice factoring, the financing company is repaid from the collected invoices. However, there is still a % of those invoices that they hold back until they collect enough invoices to begin releasing that holdback.
Once the customer pays the invoice, you then pay the lender back. If the lender only gave you a portion of the invoice upfront, you will keep the remainder of the invoice once the lender is paid back for the invoice.
The longer your customers take to pay the invoices, the more fees you owe the A/R lender. So, what happens if a customer never pays? You will still owe the lender, and you’ll have to write off the invoice as a bad debt.
What are the key differences between A/R financing and factoring?
Accounts receivable financing is often confused with invoice factoring. They are similar, though there are some critical differences.
In both cases, a business is using unpaid invoices to tap into cash needed to pay bills, buy equipment or inventory, or meet payroll. Accounts receivable financing uses your outstanding invoices as a form of collateral to obtain financing. However, with invoice factoring, you sell your invoices to a third party who will then typically collect your outstanding invoices.
A factoring company agrees to advance the business a lump sum of money based on the business’s unpaid invoices. However, the responsibility of invoice collection transfers to the factoring company, and this means they will notify your clients of the change in who is collecting their payments.
With factoring, the business is actually “selling” outstanding invoices to the “factor” – the financing company - for a percentage of the invoices’ total. When the company sells the invoices, they do not receive the full amount. The factoring company will advance you around 75% to 95% on the invoices they factor and hold the other 25% to 5% in reserve. The factor then pays you back the reserve as your customers pay their invoices. You usually end up with 97% to 99% of your total accounts receivables after all payments are collected and the 1% to 3% factoring fee is taken out.
In accounts receivable financing, the borrowing business retains ownership of the receivables and is responsible for collection. Factoring will alert your customers to the fact you’ve passed on your invoices to a third party. With accounts receivable financing, all communication is still handled by your company, so your customers will never realize their invoices have been used for getting an advance on their payments. Some might worry that notification to your customers of selling invoices can be a poor reflection of the company’s financial stability.
Is accounts receivable financing right for my business?
Typically, accounts receivable financing is advantageous when a company needs a quick influx of money to cover payroll or other cash flow emergencies. For businesses with little or no credit history (or those businesses suffering from a bad credit score), A/R financing alleviates the need for additional collateral, as the invoices serve as the collateral.
Note, however, that not all unpaid invoices are considered the same by lenders. A/R lenders know the longer customers take to pay invoices, the less likely the invoices will ever get paid, so you’ll have better luck submitting newer invoices to them.
Interested in other sources of fast financing for your business? Other options could include a merchant cash advance (see - What is a Merchant Cash Advance?) or even many Small Business Lines of Credit.
To find out if accounts receivable financing is right for your business, start your research
with the experts at Everfund today!
About the Author
Rieva Lesonsky is the CEO and president of GrowBiz Media and SmallBusinessCurrents.com. She is an award-winning business journalist and the former editorial director of Entrepreneur magazine. Her work has appeared in numerous business publications, including MSN Money, Forbes, Success magazine, NerdWallet, and many more.