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All about Accounts Receivable Financing

Updated on :  

08 min read.

Most small and medium business outfits operate through a credit system to maintain goodwill with their customers. However, if most of their business transactions are done on credit, it would put their business in a difficult position with respect to cash flow. One way of handling this situation is accounts receivable financing.

What is Accounts Receivable Financing?

Accounts receivable financing enables companies to obtain early payments on the outstanding invoices billed to their customers. Organisations using accounts receivable financing commit their outstanding invoices to a financial intermediary for payment ahead of the invoice due date, in return for a small fee.

Types of Accounts Receivable Financing

There are various types of accounts receivable financing alternatives open to businesses, which include:

1) Factoring – Factoring refers to a financing method where a company sells its receivables to a factor (third party). Usually, the company receives 70% to 90% of the accounts receivable value from the factor. The factor would then collect the final payment from the customers on maturity and send the remaining payment to the company after deducting its fee.

2) Invoice Discounting – This method of accounts receivable financing is similar to factoring. The key difference is that the responsibility for following up with customers for payments remains with the company and doesn’t pass on to the third party.

3) Asset-based Lending/Accounts Receivable Loans – These are alternate funding options that offer short-term funding. The borrower offers its accounts receivables as collateral for raising funds from the banks. The borrower continues to own the receivables and is responsible for collecting them from its debtors. The bank typically lends a fraction of the receivables’ face value, e.g., 80%-90%.

Factors that contribute to the quality of accounts receivables

Factors that are considered when assessing the quality of the accounts receivables portfolio:

1) Debtor’s Creditworthiness – The creditworthiness of the debtors is essential, as it’s eventually the debtor making the payment. Hence, a debtor with a low credit rating diminishes the receivable quality and increases the cost for the borrower in terms of fees.

2) Debtor’s Industry – The industry to which the debtor belongs is of great significance. As the macro-economic trends of that industry impact the debtor’s ability to honour their obligations.

3) Age of the Receivables – Factors or financial intermediaries usually do a careful evaluation of the age of the receivables as well as the historical treatment of the receivables before determining the financial value of the receivable portfolio. Long-duration accounts receivable have a low probability of being paid and are hence considered to be lower quality. Receivables with a short duration can improve the cash cycle of a business and are considered to be of a higher quality.

4) Quality of Documentation – It is one of the most crucial aspects in determining the value of the receivables. A clean, well-maintained, and complete chain of the title is important, as better documentation quality offers clarity of the contracts. The quality of documents also offers a basis for any legal recourse in case of default by the debtor. Hence, clear and sound documentation enhances the quality of the receivable basket.

On the whole, accounts receivable financing is slightly easier for businesses to obtain funds than other financing alternatives. This is particularly true for small business outfits that easily meet the accounts receivable financing criteria and large business outfits that can integrate technology solutions.