A Small Business Guide to Accounts Receivable Financing

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There are several ways to obtain financing depending on the balance of your accounts receivable. Read on to find out how they work and if they’re right for your business.

Many people have a healthy fear of banks. Certainly, and I have worked in several. This fear is very troublesome when your business needs financing and you start looking for a small business loan.

Fortunately, there are several non-bank financing options you can take advantage of. You can postpone the payment of your suppliers. You can get an advance from your merchant services company. Or you can use your Accounts Receivable (AR).

Overview: What is accounts receivable financing?

Accounts receivable financing involves selling your receivables directly or using the balance to secure a short-term business loan.

The main difference between underwriting AR loans and alternative business loans is that there is no focus on the income statement. The lender knows they will get the receivables if they default, so they don’t need to make sure you can make the payments.

Types of accounts receivable financing

Here are the main ways you can use your RA for funding.

Invoice financing

Invoice financing is very specialized. In five years in the banking industry, I have only reviewed one potential invoice financing deal. Usually a startup receives a significantly larger order than anything it has ever executed before, and there is no way for it to fund the manufacturing of the product on its own.

So, the startup approaches a lender for a one-time loan to buy materials and pay for labor until the customer starts making payments. The lender spends some time guaranteeing the startup, but most of the time is spent on underwriting the client because if the startup defaults, they will have to go to the client to collect.

The more specialized the financing, the more expensive it is. Invoice financing should only be used for one-time occasions if your business has no other option.

Factoring

Factoring companies are also specialized. Instead of financing a single invoice, factoring companies will buy receivables from you for a percentage of the total amount. Some are sophisticated enough to sync with your accounting software and let you choose which accounts to sell to them.

Factoring can help you get cash fast, but you might want to incorporate some of the premium into your pricing. Every AR you sell for 90% of its value immediately makes you lose 10%.

Credit line

The most common type of AR financing is through trade lines of credit. Lines of credit are intended to provide you with working capital to use to complete the sale made with the RA.

Each month, you will provide an AR Aging Report with exclusions for late payments, mergers, government accounts, and accounts canceled by a vendor account. You can then borrow up to 50-80% of that balance, depending on your credit profile and the lender.

The other two AR funding options are almost always used by businesses that are out of luck. If you are looking for a good line of credit, you will need to be in good standing with your business. If not, ask your banker to use the Small Business Administration (SBA) to do so.

3 Benefits of Accounts Receivable Financing

There are always benefits to getting more money now.

Accelerate cash conversion

A big part of your business plan for a new business — and managing working capital once you’re up and running — is determining how you’ll accelerate your cash conversion.

The longer it takes to get paid after having to shell out money for materials and labor, the slower your business will grow. The sooner you can convert sales into money, the sooner you can invest that money in new projects.

Keep it off your balance sheet

If you get a line of credit and you draw on it, you’ll need to add the balance to your liabilities. But if you factor your RA, the journal entry is to debit cash and credit receivables. The liability section is not affected.

This is useful when looking for a term loan, as your debt service will be better without the other debt payments due on the balance sheet.

Available only when needed

Some funding sources require an annual fee, often up to 1%, to be paid for the privilege of using them. AR funding is convenient when it’s available when you need it, but you only have to pay for it if you use it. This makes it easier to strategize and only use it if absolutely necessary.

3 Disadvantages of Accounts Receivable Financing

Here are some reasons to think twice before using AR funding.

You have to rely on credit sales

The first drawback relates more to the use of AR in general. Selling things on credit can be necessary, especially if you’re selling to larger companies, but the more cash sales you can make, the better. This will speed up your cash conversion and you won’t have to worry about deadbeat customers not paying.

You will have to pay more

As I mentioned earlier, the more specialized the funding source, the more expensive it is. While a normal bank loan would probably not have an interest rate higher than 8% at present, AR financing can cost up to 20% with all fees included.

If you can make it work expensively it can be effective, but don’t get so far behind the ball if you don’t have to.

You can fall behind

There is a way to create a small Ponzi scheme within your own business if you become addicted to AR funding. You take a big order and finance the production, but you can only finance 75% of the sale amount, so you make two more sales so you can cover the production and more. But now you need to be able to fund those sales, so you can do crazy discounts to make more sales to fund the other sales.

If the cost of financing is higher than your gross margin on the sale, or if you don’t have the cash to bridge the gap between financing and the cost of materials, you could fall into this trap. Sometimes it’s better for your business to slow down in the long run.

What do you call it when you get a loan from a pirate?

ARRRR financing.

All funding decisions should be made with two questions in mind: what is the cost relative to the money you can make with the funds, and what limitations does the funding place on your business? AR financing can have quite high costs, but it can be worthwhile as long as it doesn’t limit your company’s decision-making.

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