Do you want to apply for accounts receivable financing?
Continue reading, and learn everything you need to know about it.
Accounts receivable financing is for businesses with customers on credit terms.
You can leverage it to grow your business, or to get over a rough financial patch.
Imagine yourself in going through the scenario below?
Customers who owe you money stopped answering your calls. On the other hand, suppliers are chasing ferociously for payment.
Before you know it, your balance sheet shows a high receivables total. Although it is an asset, you cannot use it to pay your expenses or liabilities.
This is when accounts receivable financing becomes handy.
In this guide, we are going to show you:
- The pros and cons of accounts receivable financing.
- Things to look out for.
- The application process.
- 1 Definition
- 2 Types
- 3 Pros
- 4 Cons
- 5 What Else to Consider?
- 6 Steps to Apply
- 6.1 Determine Your Preferred Type of Financing
- 6.2 Shortlist Potential Financing Companies
- 6.3 Submit Your Application for Approval and Quotes
- 6.4 Ask the Right Questions
- 6.5 Confusing Clauses and Items
- 6.6 Flexibility of Offer
- 6.7 Legal Documents
- 6.8 References
- 6.9 Understand Impact on Invoicing Procedures
- 6.10 Send Your Invoices to Obtain Financing
- 7 Ask Your Questions
Accounts receivable financing is also known as invoice financing in the United Kingdom. It is a financing method that involves your receivables and outstanding invoices.
With this financing arrangement, a business sells its receivables to a financing company for cash. Alternatively, a business can pledge its receivables as collateral for a short term loan.
There are two types of accounts receivable financing:
- Accounts receivable pledging or invoice discounting.
- Accounts receivable factoring.
Many articles use the terms interchangeably, but there is a slight difference between them.
Accounts Receivable Pledging / Invoice Discounting
Accounts receivable pledging is known as invoice discounting in certain jurisdictions. It requires a business to pledge its receivables as collateral in exchange for cash.
How Accounts Receivable Pledging Works?
The lender will check your receivables to identify which of them qualify as collateral.
It will then confirm the amount of receivables that has met its criterias. From there, it will offer 75% to 85% of this amount as the loan.
You need to repay the loan according to the schedule agreed. Else, the lender has the right to collect all outstanding amount directly from your customers.
Accounts Receivable Factoring
Accounts receivable factoring involves a factoring company.
Instead of pledging your receivables, you are essentially selling them to the factoring company.
In return, the company will pay you 70 to 90% of the total value of your receivables, net of any related fees.
How Accounts Receivable Factoring Works?
The following process gets initiated when you agree to work with a factoring company:
Factoring company approves the credit of customers you invoiced.
Factoring company verifies the validity of the invoices with your customers.
You get 80 to 90% of the invoiced amount from the factor. The remaining 10 to 20% goes into a reserve account.
The factoring company tries to collect payment from your customers.
Your customers pay the factoring company.
The factoring company then pays you the remaining 10 to 20% of the invoiced amount.
The payment that you receive is the net of a small factoring fee.
The factoring cycle concludes when you receive the remaining amount.
The cycle repeats itself when you submit new invoices to the factoring company.
Accounts receivable financing comes with many benefits.
This section explains why business owners would choose it over other financing methods.
Improves Cash Flow
Financing your business using its accounts receivable gets you immediate cash.
You can then use the cash to fund daily operations, or to finance the purchase of an equipment.
A tough economic condition may have an adverse effect on your business. Having the extra cash puts you in a better position to weather the storm.
Reduces Urgency for Debt Collection
Debt collection is not easy.
Someone who has the patience to deal with non-paying customers is not easy to find. On the other hand, hiring a full time credit controller increases your operating expenses.
Working with a accounts receivable financing company is like outsourcing your debt collection activities. It is obvious choice for most businesses unless it comes with exorbitant finance costs.
The financing company will collect what your customers owe you on your behalf. When that is taken care of, you get the freedom to focus on other essential areas of your business.
An accounts receivable financing arrangement can be ready in about one week. This is because the requirements are less rigorous as compared to other modes of financing.
In certain industries, customers tend to take a longer period to pay. As a result, industry players rely a lot on factoring services. By doing so, cash flow becomes a non-issue as long as sales keep coming in.
Evaluation that financing companies conduct are less stringent as compared to commercial banks. This results in a shorter duration between the submission of your application and its approval.
It takes about 3 to 10 business days to set up an account with a financing company. Financing takes place within 24 hours after the account is ready.
You must not dismiss accounts receivable financing if your business needs the cash urgently.
Favorable Balance Sheet Representation
Unlike a bank loan, signing up your business for accounts receivable financing does not increase your liabilities in the balance sheet.
When a financing company agrees to exchange cash for your receivables, you can account for it by transferring the amount from accounts receivables to cash at bank. This transaction does not result in a future obligation.
To account for recourse factoring, which comes with an obligation to repay the factor if it fails to collect the sum your customers owe you, you need to account for a recourse liability in your balance sheet.
However, the amount is almost always lower than the amount that a bank loan adds to the liability section of your balance sheet.
Retain Ownership Over Fixed or Non-Current Assets
You do not need to pledge any fixed assets as collateral when you apply for accounts receivable financing.
This benefit attracts many businesses that are operating without high value assets such as machineries, land or equipment. Consulting companies, technology companies and other serviced-based companies are examples of such businesses.
There is no need to worry as well if you own many fixed assets. Your financing company cannot claim control over them. This stays true even when it fails to collect what your customers owe you.
Small Impact on Credit Score
An accounts receivable financing arrangement does not have a big impact on both your business and personal credit rating.
In fact, it might have a positive impact. Thanks to the fact that you now have a lower receivables turnover ratio, you can start paying suppliers and other payables faster.
Before jumping in and submitting your application too quickly, there are disadvantages that you must know about.
Loss of Control Over Credit Policies
Factoring or financing companies have strict policies over invoices and customers that qualify for their services.
These policies may force you into setting uncompromising credit measures for customers. You may even have to cease doing business with those with poor credit rating.
Moreover, the responsibility to collect debt may fall on the financing company, and you have no control over how it will collect debt from your customers.
The relationship between you and your customers will suffer if they adopt an aggressive method.
The convenience of financing your business with receivables comes with a price. More often than not, it is more expensive than a bank loan.
First of all, financing companies take a percentage of your receivables as fees.
Furthermore, some may charge additional interests for the difference between the day when they advance the cash, and the day when the amount is collected from your customers.
The $10,000 will accrue interests until September 5, which is when they recover the $10,000 from your customers.
Undesirable Contract Length
Avoid the following characteristics of an accounts receivable contract if your need for financing is temporary:
- Long contract period.
- Comes with a high commitment for the amount of receivables factored within a certain period.
When you do not require long term financing, latching yourself onto one of these contracts will result in unnecessary finance costs.
Financing Companies May Not Be Good Debt Collectors
Not all financing companies are good at collecting debt.
Companies with a poor track record at debt collection may have additional clauses in their agreements to protect themselves.
For example, they could charge a fee for irrecoverable debt on top of existing finance costs.
Good factoring or financing companies are confident of how they evaluate the credit-worthiness of your customers.
They will not accept invoices for customers whom they do not have the confidence to collect from. They will reject these invoices from the factoring cycle, and explain the reasons behind the rejection.
What Else to Consider?
Other than the pros and cons, there are things that you need to know before collecting quotations from financing companies.
Let us look at what are they.
Finance Cost and Fee Structure
With any financing arrangement, your goal should be to get as much financing as possible at the lowest finance costs.
Accounts receivable financing is complicated enough in theory. You can tell as you scroll through this guide.
In the real world, the way financing companies package it makes things even more confusing.
To compare the fees and interest rates imposed by different financing companies, you need to get hold of the following:
Accounts Receivable Factoring Fees
Advanced funding. Advanced funding refers to the percentage of invoice amount that you will receive once it qualifies for factoring.
Factoring fee / Discount rate. Factoring companies charge this fee for their service. It is determined by the duration taken to collect what your customers owe you.
Accounts Receivable Pledging Fees
Interest rate. Interest rate is charged based on the amount of financing given to your business.
Management fee. Management fee is a form of administrative fee. It can be charged based on the revenue of your business or a fixed fee.
Size and History of Financing Companies
Newer and smaller financing companies do not have the track record of a large financing house. They might even go out of business. Thus, they will offer lower fees to get your business.
Likewise, larger and established financing companies with credible clients may quote higher fees with little room for negotiation.
You can take the risk of signing up with an up-and-coming financing company or one with an established track record. It is entirely up to you.
Recourse vs Non-Recourse
If you are applying for a factoring service, you need to choose between recourse factoring and non-recourse factoring.
In a recourse factoring arrangement, you agree to pay for any non-collectible invoices within a set period.
This period typically ranges from 90 to 120 days.
Once the days have passed, you need to pay your factor the amount due.
You will then resume the responsibility of recovering the debt from your customer.
Non-recourse factoring, on the contrary, is an arrangement which the factoring company takes responsibility over the repayment of your invoices.
Such an arrangement is favorable towards your business, but the factor will have a stricter evaluation on the creditworthiness of your customers.
Choosing between recourse and non-recourse factoring depends a lot on the amount of receivables involved as well as the creditworthiness of your customers.
The best way to choose between the two types of factoring is to have a thorough discussion with factoring companies.
Other Financing Options
It is a good idea to compare the list of fees that you have obtained with other financing options.
Do you have fixed assets to use as collaterals for a bank loan? Are you able to take a lease if the purpose of the money is to purchase an equipment? Can a bank overdraft help overcome the temporary shortage of cash?
Always take into account all available options. You might just discover a cheaper alternative with less obligations as compared to accounts receivable financing.
Steps to Apply
Ready to apply? Let us walk you through the steps.
Determine Your Preferred Type of Financing
At this point of time, you should have a good grasp of everything mentioned above.
You must understand the type of accounts receivable financing to sign up for, the pros and cons, as well as the fee structure offered by different financing companies.
Shortlist Potential Financing Companies
Create a list of financing companies that are offering either invoice discounting or factoring services in your region.
The Internet is a good place to start. Financing companies tend to spend a lot on online advertisements. It should not be hard to find at least 5 companies.
You can also ask fellow business owners for recommendations, but this can be less effective. Many of us still relate financing to businesses with poor financial performance.
Thus, it can be hard to find a business owner who is willing to share whether they are working with any financing companies.
Submit Your Application for Approval and Quotes
The next step is to submit your application or contact details for evaluation. After the submission, the financing companies can then provide more details on their offer to your company.
Today, there are more financing companies accepting online applications. Yet, in different parts of the world, there are still financing companies that only accept application via paper forms.
These forms, whether online or offline, require relevant details about your company, the owners or officers, as well as the latest financial statements.
The creditworthiness of your existing customers matters most. The section covering accounts receivable information will get the most attention from the approving officers.
Typically, the section for accounts receivable information requires the following:
- Top receivables and the amount owed to you.
- Average monthly revenue from the receivables.
- Average invoice collection time.
- Average invoice amount.
- Current percentage of bad debt.
- Other financial information and acknowledgements.
Financing companies tend to ask for the same information.
Pick the form that requires the most details. Then, prepare the information accordingly before filling up the application forms at one go. Applying in this order will save you a lot of time.
Ask the Right Questions
If the majority of your customers have a good credit track record, you can expect to receive a quotation from a number of financing companies within a few days.
Go through the quotations. Always ask the respective financing companies if there are items in their quotations that you do not understand.
The following are some of the relevant questions that you might want to ask, especially if you are new to this.
Confusing Clauses and Items
Most of the details you need are available on the quotations or draft agreements handed to you. In fact, the sheer amount of information can confuse and overwhelm some of us.
When in doubt, ask questions. The agent or officer of your financing company is there to answer them.
Professional financing companies take the time to explain their services and offers without being desperate about closing sales. They will walk you through your concerns and make sure you are clear about the details.
If a representative is too pushy, take a step back. Do not cave in to the pressure. You can also request for another representative to serve you. Else, take your business to another financing company.
Flexibility of Offer
The quotations and draft agreements given to you are not final until you put your signature on them. Some elements may still be open for negotiation.
There might be clauses that you are uncomfortable with. For example, the threshold for invoices that you need to submit for pledging or factoring could be too high.
If you do not have a long term need for accounts receivable financing, then you might want to negotiate for a shorter contract period.
Entering into a year long agreement when you only need 6 months of financing is wasteful. Always keep in mind that we are talking about one of the more expensive financing methods here.
Last but not least, always try to negotiate for lower interest rates and fees. Presenting a legitimate quotation from competitors offering better rates may help.
It is perfectly fine to ask financing companies for legal documents and licenses issued by local authorities governing the credit industry.
This step is even more important when you are going to work with a relatively new financing company.
You do not want the financing company that you are working with to go out of business due to legal troubles with the authorities. An incident like this will adversely impact your credit line and subsequently, cash flow.
Checking on financing companies on the Internet is not like finding the perfect restaurant for your next meal.
Online reviews for financing companies are almost non-existent unless they are involved in scams or unscrupulous practices.
The better way to verify how good they are is by asking the financing company itself for verifiable references or testimonials.
Call up the individuals behind the testimonials. Inquire about their experience with the financing company. Only rely on the statements if the business that they are running is established and has been running for some years.
Some financing companies may choose to provide text or video testimonials instead. These testimonials are reliable, but most of the negative elements are often removed before being presented to potential clients.
Understand Impact on Invoicing Procedures
There are changes that you need to make on your invoicing procedures when you get involved in an arrangement for accounts receivable financing.
Find out what are the changes required and their impact on your customers and invoicing procedures.
In certain arrangements, the wordings in your invoices need to change so that payments are made directly to the financing company.
You may also need to authorize the financing company to collect outstanding payments on your behalf. As a courtesy to your customers, let them know in advance that a third party will be collecting the payments on your behalf.
Otherwise, you can remain as the recipient of the payments, but you will have to remit them to the financing company within a certain duration.
On top of all these, you need to know the timeline and procedures to submit invoices for credit evaluation, approval, and for the crediting of funds.
Larger and more established financial institutions will require the submission of invoices to be done using their system. On the contrary, smaller financing houses accept invoice submissions via email or fax.
Send Your Invoices to Obtain Financing
Congratulations! At this stage, all you need to do is to submit your invoices. The financing company will then credit your bank account with the cash you need.
Errors seldom happen, but it is always better if you can have someone within your organization, preferably an accountant or bookkeeper, to keep an eye on the transactions.
Of course, you will need to consult your accountant on how to include the related transactions into your books.
Ask Your Questions
We hope this guide has been useful in providing everything you need to know about accounts receivable financing.
Do you have experience in taking up any forms of accounts receivable financing? Share the experience with us and any lessons that you have learned from it.
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