Accounts Receivable(AR) Financing: What It Is & How It Works (2024)

15 May, 2024

10 mins

Accounts receivable (AR) refers to the money a customer owes to your company for goods or services sold. AR isn’t just a number on the balance sheet; it’s your business’s heartbeat. Each pending invoice is a commitment, a forthcoming payment crucial for your cash flow. Waiting for invoice payments can sometimes lead to cash flow challenges.

Since your company’s financial well-being hinges on these invoices, it’s crucial to leverage them, and that’s where the strategic power of accounts receivable financing comes into play. When those receivables transform into a waiting game, your business doesn’t have to hit the pause button. Instead, it can leverage the untapped potential of its accounts receivable to keep making progress.

But what is AR financing, exactly, and how does it work? Read on to find out. But first, let’s start with the basics.

Accounts receivable (AR) financing is a financial solution where a business sells its outstanding invoices to a finance company. It is a valuable option for companies needing immediate capital, helping them receive funding based on a percentage of their outstanding accounts receivable.

There are various ways to structure an accounts receivable financing agreement, it can be structured as an asset sale or a loan. However, no matter the structure, this financing allows businesses to access much-needed funds quickly, enabling them to maintain cash flow and support their operations more effectively.

Here are four of the most common types of accounts receivable financing, all of which can help your business improve its cash flow. You can choose the type of financing that best fits your needs and the specific situation.

1. Factoring

Invoice factoring is when a company sells its invoices to a factoring company, which then collects payments from its customers. By leveraging invoice factoring you can receive anywhere from 70% to 90% of the invoice value upfront. The factor takes on the role of collecting payments from your customers, lifting that responsibility off your shoulders. Once the payments are collected, they deduct their fees and hand over the remaining amount to you.

2. Invoice discounting

Now, picture a scenario where you want to retain more control over your customer interactions. Invoice discounting offers a similar solution with a twist. In this approach, you can access a higher percentage of the invoice value, often around 90%. Here, you retain the task of collecting payments from your customers. Once collected, you pay the financier the received amount and their fees.

Both methods serve the same purpose – transforming your pending invoices into immediate funds. The choice between them depends on your preference for hands-on customer interactions and your need for an immediate cash injection.

3. Accounts receivable loans

An accounts receivable loan is a type of funding where a business borrows against its accounts receivable. The lender provides cash in advance based on the value of the outstanding invoices, and the business repays the advance plus fees when the invoices are paid.

4. Purchase order financing

Purchase order financing is designed to help businesses fulfill large orders. The lender provides the necessary funds to pay suppliers. In exchange, the lender places a lien on the purchase order and related receivables until the payment is received from the customer.

AR financing helps businesses use their unpaid invoices as collateral for borrowing, helping them quickly gain access to cash for their daily needs or investing in new projects. The benefits of AR financing are pretty numerous, including:

1. Immediate access to cash: AR financing allows businesses to access cash quickly, often within a day or two of applying, helping businesses meet their expenses and take advantage of time-sensitive opportunities.
2. No need for collateral: Businesses don’t need collateral for this loan, as invoices serve as the collateral.
3. Flexible financing options: AR financing can be structured as a term loan or a line of credit, allowing businesses to choose the best option.
4. Improved cash flow: By using AR financing to access cash tied up in unpaid invoices, businesses can improve their cash flow and better manage their financial obligations.
5. Reduced risk: By using AR financing, businesses can reduce the risk of not being paid for their products or services, as the lender assumes the risk of collecting on the invoices.
6. Easy application process: The application process for AR financing is often simpler and faster than traditional loans, as the invoices serve as collateral.

Accounts receivable financing is your financial bridge, turning unpaid invoices into flowing funds. When your business needs cash, this strategy converts your accounts receivable into immediate working capital. Here’s how it works:

1. Invoice Submission: You submit your outstanding invoices to a financing partner. These invoices represent money owed to you by your customers.
2. Evaluation: The financing partner assesses the creditworthiness of your customers. This step helps determine the risk involved in advancing funds against your invoices.
3. Funding Offer: Based on their evaluation, the financing partner extends an offer. They typically advance a percentage of the invoice’s value, often around 80-90%.
4. Cash Flow Injection: You receive the advance, which helps improve your cash flow instantly. This is a boon when you have bills to pay or growth opportunities to seize.
5. Fee Structure: As part of the arrangement, the financing partner charges a fee for their services. This fee varies based on factors like invoice volume and the creditworthiness of your customers.
6. Repayment: Once your customers settle their invoices, the financed amount (plus fees) is paid back to the financing partner. This repayment completes the cycle.

Accounts receivable financing example

Here’s an example to make it easier for you to understand how AR financing works.

Imagine your manufacturing business delivered goods worth $50,000 to a reputable retailer. Instead of waiting for the payment, you decide to leverage this pending invoice for financing. A financing partner evaluates the transaction, sees the reliability in the retailer’s payment history, and agrees to advance you up to 90% of the invoice, amounting to $45,000 with an agreed-upon fee (let’s say $1,000).

This translates to a $45,000 cash infusion that immediately boosts your finances. Now, while you continue to focus on your business operations, the retailer fulfills their outstanding invoice by remitting the full $50,000.

With the invoice settled, you retain $4,000 and fulfill your commitment to the financing partner by repaying the original advanced sum ($45,000) plus the agreed-upon fees ($1,000).

This approach helps you manage immediate expenses and pursue opportunities without waiting for customer payments. It accelerates your cash flow, empowers smoother operations, and positions you to capitalize on growth prospects. It’s a strategic solution we’ll explore further as we dive into specific types tailored to fit your business requirements.

The main difference between accounts receivable financing and factoring lies in the ownership of the invoices and the responsibility for collecting payments. In accounts receivable financing, the business retains ownership of the invoices and is responsible for collecting payment from the customer. On the other hand, in factoring, the customer pays the factor directly, and ownership of the invoice is transferred to the factor. Sure, here’s a table summarizing the key points:

Now that you know how AR financing can benefit your business and how it works, it’s crucial to understand the challenges involved with this financing arrangement. So that you can decide whether it’s a good option for your business or not – with that in mind, here are a few challenges businesses face when leveraging this option:

1. Fees and interest: The cost of AR financing can typically be higher than traditional loans, making it an expensive option.
2. Dependent on customer payments: If customers fail to pay these invoices on time, it can create issues for the financing company and, in turn, impact the business’s ability to access funding as this financing is based on unpaid invoices.
3. Potential impact on customer relationships: If you use a factor to collect money on your behalf, it can impact your relationship with your customers.

AltLINE, 1st Commercial Credit, Porter Capital, OTR Solutions, Apex Capital Corp, RTS, Phoenix Capital Group, and Porter Freight Funding are the top accounts receivable financing companies.

These companies help businesses improve their cash flow and manage their outstanding invoices. They provide competitive rates and fees, quick funding, flexible contracts, and efficient invoice processing.

1). What is trade receivables financing?

Trade receivables financing refers to supply chain finance where businesses can gain access to the money owed to them by the customers before the invoice payment date is reached. It’s used to access working capital trapped in the supply chain, helping improve the cash flow.

2). What are the two methods for financing accounts receivable?

The two methods for financing accounts receivable are AR Financing & Invoice Factoring. AR financing involves borrowing money against outstanding invoices at a percentage of their value. In contrast, invoice factoring involves selling outstanding invoices to a third party, known as a factor, at a discount.

3) What is the meaning of accounts receivable in finance?

It refers to the outstanding invoices or money owed to a company by its customers for goods and services provided on credit. It is recorded as an asset on the company’s balance sheet, representing future cash payments the company expects to receive.

Proper AR management is crucial for maintaining cash flow and ensuring timely collection of payments from customers.

4). Who are accounts receivables lenders?

Accounts receivable lenders are financial providers that offer financing options to businesses by leveraging their outstanding invoices. They play an essential role in providing flexible financing solutions to businesses that may have difficulty accessing other forms of credit.