Updated July 17, 2023
Accounts Receivable Financing Definition
Every company needs capital to operate. Accounts receivable are revenues that are accrued but not yet received. Accounts receivable financing refers to financing that a company receives for a portion of its accounts receivable. As the revenue is yet to receive, financing is claimed by the company on the upcoming revenue.
Account receivables are liquid assets that are the kind of assets that can be converted into cash quickly. The company needs cash to operate day-to-day transactions. So the cash will be freed once the money is received for accounts receivable. A few companies have long cash conversion cycles, so they prefer to go for accounts receivable financing, where the cash is received based on the total accounts receivable.
How Do Accounts Receivable Financing Work?
There are mainly two ways by which receivable financing works.
- Selling of Assets: This happens when the company sells the accounts receivable to lenders as an asset. The lender takes responsibility for recovering the accounts receivable on behalf of the company, as accounts receivable are primarily short-term assets for the companies. So this is profitable for the lenders, as they only provide 85% to 90% worth of receivables as financing.
- Issuance of Loan: Loans can also be issued by keeping the accounts receivable as collateral. This makes the loans secured, and the company receives advance on the pending accounts receivable. This process helps the company to keep the receivables under its books.
Company XYZ has receivables worth $100,000. Its working capital needs are high, and the cash conversion cycle is also high. So it will take a few months for receivables to convert into cash, which can be used for meeting working capital needs. So the company can opt for Accounts Receivable financing.
Company XYZ will have to find a financer ready to pay in advance by taking the receivables as collateral. So once the company receives the advance, it can use the cash in the business to meet its working capital requirements.
It is highly beneficial for businesses as it helps businesses to free up cash and use it to meet daily operation goals. Cash is an essential requirement for a business to run. Accounts Receivable, though it stands as a liquid asset, still sometimes takes time to be converted to hard cash. It also helps businesses run properly by keeping the receivables as collateral or selling them. The lenders provide a good lending opportunity for firms with high liquidity demand.
Accounts Receivable Financing vs Accounts Receivable Factoring
Accounts Receivable Financing refers to financing where the receivables are kept as collateral, and financing is obtained based on the magnitude of the receivable. Say a total of $100,000 is there in the receivable, and 98% of the asset value is received as an advance.
Factoring firms are different; they buy the receivable from the companies and provide advances based on the percentage of the total asset value. If the asset value is $500,000, the factoring company can provide 90% of the asset value and then engage in the recovery process of the receivable. It is quite known that all the company’s customers will not make payments simultaneously. So the factoring company gets paid for the risks they take regarding the collection time and uncertainty.
- Working Capital requirements can be easily met as the firm will not have to wait for customers to pay off the receivable. The receivable can be converted to cash as per the company’s will.
- Companies don’t have to take high-interest loans to meet sudden cash requirements. So receivable financing helps a firm to meet its requirement without issuing loans.
- Taking a loan increases the bankruptcy cost of the company as the interest burden increases. Still, factoring is counted as a loan, so it keeps the balance sheet clean and helps to raise money without increasing debt.
- Accounts receivable requires less legal documentation than taking a loan, so it helps to get the financing faster than another loan process.
- The process is stress-free. At times it gets really difficult to recover money from customers. So as the lender is dealing with the stress of recovering money, so the company can concentrate on the main business processes.
- As the recovery from the customer is given to another party, then there is a risk that the company might lose the customer. At times the recovery agents are hard on the borrowers, so the risk of losing the business lies with the company.
- It shows that you don’t have control over your customers and are not sure about the receipt of your payments. So it portrays a bad picture of the company.
- At times the cost of Accounts Receivable Financing is more than usual financing methods. So one must be careful before obtaining this method.
Accounts Receivable Financing helps to increase the liquidity of a company. The cost for this financing is generally more, so the company should always perform a cost-benefit analysis to decide on the best financing method. Sudden working capital requirements can always be met by using Accounts Receivable Financing.
This is a guide to Accounts Receivable Financing. Here we also discuss the definition and how accounts receivable financing works. Along with advantages and disadvantages. You may also have a look at the following articles to learn more –