Definition of Accounts Receivable Financing
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 their accounts receivable. As the revenue is yet to receive, so financing is claimed by the company on the upcoming revenue.
Account receivables are liquid assets that are the kind of asset that can be converted in 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. As few companies have long cash conversion cycle, so they prefer to go for accounts receivable financing, where the cash is received based on the total accounts receivable.
How Does Accounts Receivable Financing Works?
There are mainly two ways by which the accounts receivable financing works.
- Selling of Assets: This happens when the company sells the accounts receivable to lenders as an asset. The lender takes the responsibility to recover the accounts receivable on behalf of the company. As accounts receivable are mostly short term assets for the companies. So this is profitable for the lenders, as they only provide 85% to 90% worth of accounts receivable as financing.
- Issuance of Loan: Loans can also be issued by keeping the accounts receivable as collateral. This make the loans secured and the company receives advance on the accounts receivable that is pending. This process helps the company to keep the accounts receivable under its books.
Example of Accounts Receivable Financing
Company XYZ has accounts receivable worth of $100,000. Its working capital needs are high and cash conversion cycle is also high. So it will take few months for accounts receivable 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 which is ready to pay advance by taking the accounts receivable as collateral. So once the company receives the advance, then the company can use the cash in business to meet its working capital requirements.
Accounts Receivable Financing and Businesses
Accounts receivable financing is extremely beneficial for businesses as it help businesses to free up the cash and use it to meet daily operation goals. Cash is the most important requirement for a business to run. Accounts Receivable though stands as a liquid asset, still at times take time to be converted to hard cash. Accounts receivable financing help businesses to run properly by keeping the receivables as collateral or by selling them. The lenders provide a good lending opportunity for firms in high demand for liquidity.
Accounts Receivable Financing vs Accounts Receivable Factoring
Accounts Receivable Financing refers to the financing where the accounts receivable are kept as collateral and financing is obtained based on the magnitude of the accounts receivable. Say a total of $100,000 is there in the accounts receivable and 98% of the asset value is received as an advance.
Factoring firms are different, they buy the accounts receivable from the companies and provide advances based on the percentage of the total asset value. If the asset value is $500,000, then the factoring company can provide 90% of the asset value and then engage in the recovery process of the accounts receivable. It is quite known that all the customers of the company will not make payments at the same time. So the factoring company gets paid for the risks they take regarding the collection time and uncertainty.
Advantages of Accounts Receivable Financing
Some of the advantages are given below:
- Working Capital requirement can be met with ease as the firm will not have to wait for customers to pay off the accounts receivable. The receivable can be converted to cash as per the will of the company.
- Companies doesn’t have to take high-interest loans in order to meet sudden cash requirements. So accounts receivable financing helps a firm to meet its requirement without issuing loans
- Taking loan increases the bankruptcy cost of the company as the interest burden increases, but factoring is counted as loan, so it keeps the balance sheet clean and helps to raise money without increasing debt.
- Accounts receivable requires less legal documentation as compared to taking loan, so it helps to get the financing fast as compared to another loan process.
- The process is stress free. At times it gets really difficult to recover money from customers. So as the stress of recovering money is being dealt by the lender, so the company can concentrate on main business processes.
Disadvantages of Accounts Receivable Financing
Some of the disadvantages are given below:
- As the recovery from 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 risk of losing the business lies with the company
- Accounts receivable financing shows that you don’t have control on your customers and you are not sure regarding the receipt of your payments. So it portrays a bad picture for 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 kind of financing is generally more, so the company should always perform a cost-benefit analysis in order to decide on the best financing way. 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 does accounts receivable financing works? along with advantages and disadvantages. You may also have a look at the following articles to learn more –
- Accounts Payable Credit or Debit
- Accounts Receivable Process
- Accounts Payable Cycle
- Accounts Receivable Aging