accounts-receivable

A Business Owner’s Guide to Accounts Receivable Loans

Dane Panes | January 31, 2022

Contents

    Key Takeaways

    • Accounts receivable loans allow businesses to take out a cash advance against their customer’s outstanding invoices. When approved, companies can get as much as 85% of the total value of the invoices financed.
    • Accounts receivable financing is different from accounts receivable factoring in a way that you retain control over your accounts receivable ledger in accounts receivable financing. In accounts receivable factoring, you’ll be selling your invoices to the factor which ultimately gives them control over the company’s ledger.
    • Generally, accounts receivable financing is best suited for businesses structured as B2B or B2G holding a large volume of unpaid customer invoices.
    • The advantages of invoice financing include a quick cash flow boost, no additional collateral required, availability to businesses with bad credit standing, and faster approval. But the funding can be expensive, and there is a risk of customers defaulting on the invoices.

    Cash flow gaps because of unpaid customer invoices can be one of the biggest problems many businesses face. If left unaddressed, this can put the company in a financial strain, making it difficult for them manage their finances.

    Fortunately, business financing options like accounts receivable loans, or invoice financing, allows businesses to use their outstanding customer invoices to free up capital. This cash flow boost helps them resolve cash flow gaps and invest in revenue-generating initiatives to keep their business striving.

    If you’re considering applying for accounts receivable financing, it’s essential that you understand what the funding entails. In this article, we’ll talk about everything you need to know about accounts receivable financing, so you’ll know exactly what to expect if you decide to apply for one.

    What are Accounts Receivable Loans?

    Accounts receivable financing, also called invoice financing, is a business funding method that uses the company’s outstanding customer invoices to secure funding. Once approved, the financing company will only advance up to 85% of the total value of the invoices.

    Businesses are given some flexibility when it comes to how they can use the financing’s proceeds. In general, accounts receivable financing can be used towards:

    • Meet day-to-day expenses
    • Improve cash flow
    • Pay employees
    • Replenish inventory
    • Pay suppliers

    Additionally, you won’t have to pledge another asset as collateral with accounts receivable financing. The invoices will be enough to secure the loan until it’s paid in full. However, it is worth noting that the financing company may charge a factor rate for every week that the invoices remain outstanding.

    How does Accounts Receivable Financing Work?

    Accounts receivable financing allows businesses to free up cash tied up to their invoices. Once approved, companies won’t have to wait 30, 60, or 90 days to receive payments from their customers. With accounts receivable financing, they can advance capital to manage their cash flow, pay their suppliers, or invest in business opportunities.

    Here’s how the financing works.

    First, you choose the invoices you want to finance. Typically, large invoices with longer repayment terms would be the most ideal. You can also choose to invoice your entire accounts receivable ledger. You then find an accounts receivable financing company that would be willing to finance your invoices. Once approved, you can get somewhere between 85% to 100% (if you have creditworthy customers and healthy financials) of the total value of your financing funded. You can then use the proceeds to cover any business expenses.

    Once the payment terms are up, you (the business) will be in charge of the payment collection. You’ll have to pay the invoice financing company with the amount you receive, plus the fees. The fees you’ll owe will depend on the financing company you work with. In general, invoice financing companies may charge a 1% to 3% interest on the invoices. They will also charge another late payment fee for every week that the accounts receivable remains unpaid.

    Accounts Receivable Financing vs. Accounts Receivable Loans

    As you continue your search on accounts receivable financing, you might come across another variation of the financing called accounts receivable factoring. Both have the same purpose, which is to free up cash from the outstanding invoices. However, they do have differences that make them distinct from one another.

    One of the most notable differences between the two types of financing pertains to the control of the accounts receivable ledger. In accounts receivable financing, you retain full control of your customer’s outstanding invoices. That means you can choose which accounts receivable to finance and will be in charge of the payment chasing and collection. You will be responsible for the losses if your customers don’t settle their accounts.

    On the other hand, in accounts receivable factoring, you will have to sell your invoices to the factor, which is essentially the financing company. Once the factor advances you the money, they will take control of your accounts receivable ledger and will ultimately take on the payment chasing and collection. As such, there’s a high chance that your customers will know that you’re working with a factoring company, which other business owners may not find ideal.

    Moreover, accounts receivable factoring will essentially come with more expensive fees. This is because they will be taking over the payment collection, meaning there’s lesser effort on the borrower’s side. There’s also the risk associated with the funding. Since the business sold their invoices to the factoring company, the factor will take on the losses if the customer doesn’t pay their invoices.

    Typically, accounts receivable factoring comes with a 2% to 4.5% monthly fee, while accounts receivable financing fees could hover between 1% to 3% per month.

    When to Choose Accounts Receivable Financing

    Invoice financing and factoring can be a helpful resource if your business experiences cash flow gaps because of unpaid invoices. However, like other types of financing options, it is not a one-size-fits-all solution.

    Essentially, choosing accounts receivable financing would be worthwhile if:

    • You can’t qualify for a traditional bank loan (which usually offers the best terms)
    • Most of your capital is tied up in unpaid customer invoices, and you need to address your financial obligations or time-sensitive business opportunities
    • Your business is rapidly growing, and you need extra capital to keep up with the demands
    • You don’t want your customers to be aware of the financing and have the resources to collect customer payments without outside help
    • You’re looking for a more affordable alternative financing option

    How to Qualify for Accounts Receivable Loans

    It’s typically easier to qualify for an accounts receivable loan than a traditional bank loan. SMEs with a business-to-business (B2B) and business-to-government (B2G) model with an outstanding customer invoice can apply for accounts receivable loans.

    The requirements the businesses have to meet will largely depend on the financing company. In general, the lender will look at the invoice quality along with the customer’s repayment behavior and credibility when deciding whether they will fund the invoices or not.

    In assessing the invoice quality, the lenders will specifically look at the following factors to determine its eligibility:

    • Invoice age. Invoice financing companies consider newer invoices to be more valuable than older ones. This is because more recent invoices have better chances of getting settled. The older the invoices get, the riskier it is for financing companies. To mitigate the risk, they’re more likely to charge higher rates and fees.
    • The business’ client’s company size. Larger companies usually have higher annual revenues and good credit standing. That means they’re less likely to default on the payments – considering the impact it would do on their company. On the other hand, clients who occasionally experience cash flow gaps are riskier, which is why invoice financing companies avoid funding these types of receivables as much as possible.
    • Invoice amount. The smaller the invoice(s) are, the less likely it is to get paid. Many financing companies don’t want to take that gamble.

    Additionally, invoice financing companies may also look at the business’s creditworthiness, financials, and repayment behaviors to determine the financing’s rates and terms. Essentially, the better your financial and credit background is, the higher your chances are of qualifying for ideal terms.

    Pros and Cons of Accounts Receivable Financing

    In reality, every financing option has its set of advantages and disadvantages. Accounts receivable loans are no exception. If you’re planning on applying for financing for your business, you should know about these so you can make a more informed decision before applying.

    Here are the pros and cons of accounts receivable loans.

    Pros

    1. Quick cash flow boost

    Businesses offering net terms to their customers are prone to cash flow issues. This makes it harder for them to meet their monthly financial obligations. Instead of waiting 30, 60, or 90 days for customer payments and risking cash flow gaps, you can take out a loan against your outstanding customer invoices for a quick cash flow boost.

    With more capital, you can meet your financial obligations on time and avoid missed payments which can be detrimental to your company’s financial and credit background.

    2. No additional collateral required

    As mentioned, invoice financing doesn’t require the borrowers to pledge additional collateral to secure the loan. The invoices themselves will serve as security. This means you won’t have to put another valuable asset (e.g., real estate, equipment) in line and risk losing it if the company cannot pay off the borrowed amount.

    3. Businesses with bad credit standing can apply

    Again, the requirements for invoice financing may vary depending on the financing company you work with. However, since there is collateral (i.e., your invoices) involved, you’ll find most lenders to be more flexible with their qualification criteria.

    Moreover, the financing company will primarily base the invoices’ eligibility for funding on the business’ customers’ creditworthiness and repayment behaviors. That means that even if you have a less than stellar credit score, you can still get approved.

    4. Faster approval

    Accounts receivable financing is only accessible through alternative lenders. That said, you can expect the application process to be much faster than when you’re applying for a traditional loan. Many may also offer online applications, which are typically faster. In some cases, the business can receive a decision within a day. Funding can take place 24 hours after loan approval.

    Cons

    1. More expensive than conventional loans

    Accounts receivable financing is a much more affordable option than factoring. However, compared to conventional business loans, the fees you’ll have to pay for the accounts receivable financing can be more expensive. Additionally, if your customers fail to settle their accounts within the agreed-upon repayment term, the fees could accumulate, and your total repayment amount will increase.

    Furthermore, the fees you’ll be paying would also be dependent on the lender you’ll work with, the invoices you’ll finance, your customer’s creditworthiness, and your business financials.

    2. Risk of invoice non-payments

    If your customers don’t pay their invoices at all, not only will you be paying late fees, but you’ll ultimately shoulder the losses. You’ll have to repay the lender for the amount you owe in full. If you’re already experiencing issues with cash flow, this non-repayment of the invoices could further strain your finances and put your business in danger.

    Accounts Receivable Loans FAQs

    1. How much do accounts receivable financing cost?

    It depends on the lender. It can be difficult to evaluate the costs ahead of time as late fees may be involved – which are calculated only when all the invoices have been paid.

    But what we can tell you now is that the cost of the financing will ultimately come down to three things:

    • Time it takes for the customers to pay
    • Fees the financing company charges
    • Factor fee (1% to 3% of the invoice value)

    You can also use a loan calculator to understand the fee structure of accounts receivable financing better.

    2. What documents do I need to prepare when applying for accounts receivable financing?

    Unlike bank loans, lenders offering accounts receivable financing don’t require as many documents. In general, you will only be asked to submit the following documents:

    • Driver’s license
    • Voided business checks
    • Bank statements
    • Financial statements
    • Personal and business credit score

    3. What industries can benefit the most from accounts receivable financing?

    By the nature of invoice financing, companies with B2B or B2G structures with a large volume of outstanding invoices can benefit the most from accounts receivable financing. This includes businesses under the following industries:

    • Real estate
    • Healthcare
    • Retail
    • Consulting
    • Manufacturing

    The Bottom Line

    Overall, accounts receivable loans can be a helpful financial resource if your cash flow is tied up on your outstanding customer invoices. The application process is faster, and you can get funded within 24 hours after approval. This makes it an excellent loan option if you’re in a hurry to get your hands on extra capital.

    However, it’s worth noting that accounts receivable financing can be expensive, especially if your customers don’t pay on time. That said, if you’re planning on applying for accounts receivable loans, working with creditworthy customers will help lower your fees so it won’t cause further strain on your cash flow.

    About the Author

    Dane Panes started freelance writing in 2017. Since then, she has written about a lot of topics for different businesses. She started writing for SMB Compass in March 2020 and has been a full-time content writer ever since. Now, she focuses mostly on topics related to entrepreneurship and business financing.