What is Receivables Financing?
Receivables financing — also referred to as “accounts receivable financing” or “A/R financing” — is a trade finance method that businesses can leverage to unlock funding from outstanding invoices. These invoices are sometimes referred to as “trade receivables” and can be a valuable asset for accessing funding in a timely manner. Businesses that operate under payment terms in excess of 30 days typically have the most to gain from receivables finance due to their need for working capital.
Types of Receivables Financing
Factoring: Factoring is a financing method that involves a company selling its receivables to a third party, known as the factor. Typically, the company will receive between 70% and 90% of the value of the chosen receivables from the factor to begin with. The factor will then collect the payment on the invoices from the company’s customers when they are due and will remit the remaining payment to the company after deducting a fee (typically around 2-3%).
Invoice discounting: Invoice discounting is a similar method to factoring, but the main difference is that the company retains the responsibility for collecting payment from its customers. As a result, invoice discounting is often done discreetly, as the customers may not be aware that the company is using this method.
Asset-based lending: Asset-based lending (ABL) is another major category of receivables financing. While the two previous methods describe a process in which the outstanding invoices are sold to a third-party, ABL enables companies to secure loans based on the value of their accounts receivable. These loans can also be secured by using other assets as collateral such as inventory or equipment.
Supply chain finance: Also referred to as reverse factoring, supply chain finance programs are a type of financing solution that helps to manage the cash flow of a company’s supply chain. It involves the use of financing tools and strategies to ensure that suppliers in a company’s supply chain receive prompt payment for their goods and services, while the company itself has more flexibility to meet financial obligations.
Dynamic discounting: Dynamic discounting is a trade finance method in which a buyer and seller agree to mutually beneficial payment terms. With a dynamic discounting program in place, a buyer can offer to pay its suppliers before the agreed upon payment date in exchange for a discounted rate. Conversely, the seller can offer the buyer a discounted rate in exchange for expedited payment. This is often referred to as an early payment discount. Unlike the previously mentioned receivables financing methods, dynamic discounting does not involve a financial institution and is simply an arrangement between buyer and seller.
Benefits of Receivables Financing
Increased cash flow: A clear advantage of accounts receivable financing is that it results in an immediate boost in working capital. With receivables financing, businesses are able to access funds from their unpaid invoices which allows them to meet financial obligations and reallocate working capital to growth opportunities. Using these methods, businesses can get access to their capital in 1-2 days compared to several weeks with traditional bank loans.
No equity dilution: Receivables financing does not require businesses to dilute equity shares in order to access working capital. In traditional capital formation, businesses are often required to forfeit equity in exchange for funding. This can be a major detractor to business owners faced with a working capital dilemma.
Flexibility: Many small and medium businesses (SMBs) struggle to qualify for traditional bank loans due to their limited credit history, or lack of assets. Additionally, SMBs may have limited access to working capital compared to large corporations. Receivables financing offers greater flexibility compared to traditional solutions when it comes to addressing working capital challenges.
Improved supplier relationships: companies that implement supplier financing programs report overall increased supplier satisfaction and longer supplier relationships. Supplier financing programs allow vendors to receive payment faster through a reverse factoring agreement. This often allows buyers to access early payment discounts and strengthens trade relationships.
Drawbacks of Accounts Receivables Finance
Cost: Receivables financing can incur greater upfront costs in the form of fees compared to a traditional bank loan. This is largely due to the flexibility it offers over traditional funding solutions. Receivables financing is also made available to businesses that may not qualify for traditional bank loans. It is important for businesses to evaluate all of their options when considering one of these financing methods.
Stigma: The idea that receivables financing is a “last resort” for companies struggling financially is a stigma pervading the industries that stand to benefit most from it. This misrepresentation often stems from a fundamental misunderstanding of things like working capital ratio and opportunity cost. In reality, accounts receivables financing is a useful tool for businesses with longer payment terms and high operating costs.
Is Receivables Financing right for you?
If you suffer a serious injury, you need immediate medical attention. It’s no different when your business is experiencing cash flow problems. In some cases, businesses don’t qualify for traditional loans or don’t have time to go through a bank. Cash shortages can lead to all sorts of problems including missed payrolls, upset vendors and potential bankruptcy. If these problems tend to be top of mind, then receivables financing may be a great option for your business.
It is advisable to seek guidance from a financial expert or a reputable receivables financing provider to assess whether this funding alternative aligns with the unique financial requirements of your business.