Commonly known as factoring, accounts receivable (AR) financing is one of the oldest types of commercial financing. In simple terms, it is a process that entails the selling of receivables or outstanding invoices at a markdown to a specialized factoring or finance company—normally called "the Factor". The factoring company assumes the risks on the receivable and in return issue your business with a swift influx of cash. The amount value issued on the receivable largely depends on the "age" and quality of the receivable.
The benefits of accounts receivable financing for businesses can be hard to resist. The system offers the lure of getting immediate financing to enhance business growth.
AR Financing and Small Businesses
Going by the current trends, it may be arguably noted that traditional, mainstream micro-business financing—like credit and business loans—are inadequate. Many small business owners find this type of financing outside of their reach. Nevertheless, small business owners still realize the need to acquire financing to grow their businesses and curb cash flow shortages. Often, business owners will utilize their accounts receivable book as an avenue to financing. However, they must be aware of the particular requirements and limitations of seeking such funding.
Loan or Asset Sell
AR financing can take various forms. The business owner using this method must understand if their agreement is structured as a loan or as a sell of assets. Accounts receivable are unpaid and outstanding bills that are due to a business. On a balance sheet, these items fall into the category of a current asset and are seen as one of a company's liquid assets. Liquid assets are those possessions that can be turned into cash easily,
Most of this type of financing takes the form of a sell of company assets. Here, the due accounts are sold to another company in return for cash. The lender will usually pay only a portion of the total AR value to the business. Once sold, the lender assumes the responsibility of collecting the debt.
Loan and Collateral
When the AF financing is structured as a loan, the AR book is seen as collateral to the loan. The company retains the ownership of the AR book and the duty to collect on those debts. Business owners should ensure that the deal has a prime rate, which in essence is the varied interest amount. They should find out how the prime rate is calculated and whether it is tied on the factoring. Keep in mind that a prime rate is an essential part of accounts receivable financing.
Dating the Invoice
The purchase date is another element of the agreement that you must put into perspective. In normal cases, invoices are payable within more than 180 days. Factoring companies prefer invoices that are newer and have a longer collection shelf-life than those that are near term or delinquent.
Length of the Agreement
The length of the AR financing agreement is important for the business to consider. Whether the AR agreement goes for months, a year or several years can have varying impacts on a company. Be sure that you are well aware of the length of the agreement, and whether a short-term or long-term agreement will be vital for your business.
Full Recourse, Reserve Accounts, and Reserve Amounts
Some AR financing may include a full recourse clause. Under this provision, the lender can force the business to pay any invoices that are uncollectable after a specified period.
Some agreements allow the factoring companies to take a percentage of the paid invoices and place those funds into a reserve account. The reserve account will help to cover any uncollectable invoices.
Finally, contracts may contain a reserve amount condition. This clause allows the factoring company to withhold some of the finance funds until invoices are paid.
In truth, every business financing option has its good and bad sides. Accounts receivable financing is no exception:
- No Need for Collateral: It is a type of unsecured business financing option that does not require any collateral in the form of assets and guarantors.
- Retain Ownership of Your Business: This type of financing does not require you to give out part of your business ownership to acquire finances.
- Higher Costs: While it is a quick way of accessing cash for your business, it may come at higher costs than the rates charged on other types of business loans. Remember that failure to pay back the amount within the predetermined period will only increase the total amount that you will be required to pay.
- Lengthy Contracts: Some agreements can be short and viable, but others can be long and winding than you would like. It is crucial, however, to negotiate the length of the contract that perfectly works for you and your business.
Any form of business, whether small or big, will at one point require business credit to support various day to day operations of the business. At one point, the business may require quick money to fix its operations. Sadly, credit access has become so tight, especially to small businesses with many traditional lenders unwilling to offer viable help. Accounts receivable financing can help businesses overcome those financial challenges.