What is Accounts Receivable Financing? How It Works

Published 17th April, 2023
Last updated 29th November, 2023

Accounts Receivable Financing FAQs

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What is Accounts Receivable Financing: How It Works

Selling on invoice can be hugely beneficial for a business, given 95% of buyers prefer not to pay upfront. Providing buyers with a preferable payment method helps to improve customer experience overall and increase B2B sales. In the business world, having enough money for smooth operations is crucial, especially for business structures such as LLCs and corporations who sell on net terms. Accounts receivable financing is a strategic tool for these businesses, helping to improve their cash flow quickly.

But it can come at a cost…

Sellers have to wait until the end of the invoice term to receive payment, creating considerable cash flow issues for example. This is why many businesses turn to accounts receivable financing.

Accounts receivable financing, also referred to as trade receivables financing or AR financing is a method of short-term funding that gives sellers access to a portion of their accounts receivable. Money owed to a business, through invoice sales for example, can be accessed in the form of a loan with the help of a lender.  

The amount of working capital that can be unlocked through AR financing is based on what’s tied up in a business’ accounts receivable (AR) – the balance of outstanding money due to them for goods or services delivered or used but not yet paid for by customers. This, in other words, is their unpaid invoices.

In the business world, having enough money for smooth operations is crucial, especially for those who sell on net terms. Accounts receivable financing is a strategic tool for these businesses,  helping to improve their cash flow quickly.

Table of contents

1. How does accounts receivable financing work?
2. Types of accounts receivable financing
3. Accounts receivable financing vs accounts receivable factoring
4. Who benefits from accounts receivable financing?
5. Accounts receivable financing advantages and disadvantages
6. The B2B financing landscape
7. B2B Buy Now Pay Later - The modern accounts receivable financing

‍‍How does accounts receivable financing work?

With accounts receivable financing, a lender gives you a portion of the money your customers owe upfront—usually up to 90%. When your customer pays their invoice, you get the rest, minus a fee from the lender.

These fees can differ, ranging from 1-5%, depending on the financing company. It's important to note that the fee you pay depends on how quickly your customer pays. The longer your customer takes to settle their invoice, the higher the cost for you.

Key points:

• Your unpaid invoices are used as collateral to secure a loan
• You still assume responsibility for collecting payment

Here’s what the process of accounts receivable financing looks like:

1. Apply and secure financing: Let's say you have a €20,000 invoice with 30-day payment terms. After submitting your application, the lender approves you for an advance of 80% (€16,000) on the invoice amount.
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2. Secure financing: You can then use the funds as you wish to run your business. The lender will charge you an agreed fee, which could be per day or per week, depending on the agreement. For example, if the fee is 3% per week, the lender would charge you €600 (3% of €20,000) for every week it takes your customer to pay the invoice.
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3. ‍Payment collection from your customer: Your customer pays their invoice after 3 weeks. You then owe the lender a fee of €1,800 (3% of the total invoice amount per week for 3 weeks).
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4. ‍Repayment to the lender: After receiving payment from your customer, you have €4,600 left, which you can keep. You then repay the lender the original advance amount plus fees, which amounts to €17,800.

To understand the true cost of invoice financing, it's important to consider the lender fees as an annual percentage rate. In this example, the approximate annual percentage rate would be 62.4% (based on a 3% weekly fee for three weeks on the total invoice amount of €20,000).

Types of accounts receivable financing

There are various types of accounts receivable financing available to businesses, providing immediate cash flow by utilising outstanding invoices or accounts receivable. Here are some common options:

1. Factoring: In this method, businesses sell their accounts receivable to a financial institution, known as a factor, at a discounted rate. The factor takes responsibility for collecting payments from customers, while the business receives an upfront cash advance based on the discounted invoice value.
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2. Asset-Based Lending (ABL): ABL involves using accounts receivable as collateral for obtaining a line of credit. Lenders extend a percentage of the eligible receivables, allowing businesses to draw funds as needed and pay interest on the borrowed amount.
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3. Invoice Discounting: Similar to factoring, invoice discounting lets businesses retain control over collections. In this case, invoices are used as collateral for a loan, and businesses receive a percentage of the invoice value upfront. Repayment, including fees and interest, occurs once the customer pays the invoice.
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4. Supply Chain Finance: Also known as reverse factoring, supply chain finance involves collaboration between buyers, suppliers, and financing institutions. Buyers' financial institutions provide early payment to suppliers for approved invoices, often at a discount. Later, buyers repay the financial institution.

Accounts receivable financing vs accounts receivable factoring

Although these two terms are sometimes used interchangeably, AR financing and AR factoring are two different things. 

The key difference between these two financing methods lies in how the invoices are utilised. In AR factoring, the lender pays you a portion of the invoice upfront but now owns the invoices, bought from you at a discount. This means they are the ones responsible for collecting payment. With AR financing, you keep ownership of the invoices and use them as collateral to secure a loan or line of credit.

 After the AR factoring company buys your invoices, they provide you with cash upfront, and collect the due amount from the buyer themselves.

Once your customer settles their invoice, the factoring company then gives you the rest of the money minus their factoring fees. Typical invoice factoring rates are between 1% and 6%. Factoring companies can charge hidden fees on top of this though:

ACH fee: This fee is charged by the factor's bank for wiring funds to your account. Sometimes this is called a wire fee.

Application fee: This fee can be a flat or percentage fee and may differ from one factoring company to another.

Invoice processing fee: This is charged for getting your unpaid invoices processed in the back office.

Closing fee: This is an extra amount that the factoring company keeps from the invoice.

Monthly fee: If you sign a contract that requires you to sell a certain percentage of your invoices each month, you could end up paying a monthly fee if you don't meet the minimum.

Termination fee: If you sign a factoring agreement or long-term contract and want to end it early, you may be charged a termination fee.

Read more about debt factoring.

Who benefits from accounts receivable financing?

If your business regularly sends out invoices and your customers pay on time, accounts receivable financing could be a great fit. This helps you stay on top of payments.

It's especially useful if getting a regular small business loan is a challenge for your business. Because your invoices act as a safety net, lenders might be willing to work with you, even if your credit score isn't high or if you haven't borrowed before.

Just remember, this financing is usually short-term. It's perfect for handling immediate needs, like quickly acquiring inventory or covering unexpected costs. But each invoice that you finance or factor will cost you. Making a habit of this type of financing over a longer period of time can impact your growth rate or expansion plans.

Accounts receivable financing advantages and disadvantages

So what makes a business choose one type of accounts receivable financing over another? To understand this in more details, here are some advantages and disadvantages of accounts receivable financing:

Advantages

Quicker cash flow

Unlike traditional loans, you don't have to go through a long process to get the money you need. AR financing is a faster way to get the financing you're looking for.

And the best part is that it boosts your cash flow. Instead of waiting for invoices to be paid, you can use your assets whenever you need to secure additional financing. This is super helpful for businesses that are growing fast and need cash quickly.

 Guaranteed income
AR financing not only speeds up cash flow but also frees you from the hassle of chasing overdue invoices. With AR finance, you can borrow money that's usually stuck in unpaid invoices, making it less crucial to aggressively pursue debtors for immediate payment. This means you can concentrate more on making the most of your working capital without being constantly distracted by the need to chase down payments.

Cost-Effective Solution

AR financing stands out as a cost-effective choice when compared to other methods of managing working capital. Notably, it's faster, more affordable, and less restrictive than going for a traditional bank loan. Choosing AR finance can save you both time and money, offering a more user-friendly and efficient approach to managing your financial resources.

Minimal Credit Hassles

With AR financing, your credit score worries can take a back seat. Since your invoices serve as collateral, lenders focus more on your customers' creditworthiness and payment track record. This often means you can qualify even with a less-than-perfect credit score.

Ownership of invoices

When you receive AR financing, you retain ownership of your unpaid invoices. So although you are still responsible for collecting payment, you’re able to maintain your relationships with your customers. In this instance, your customers won’t be contacted by a 3rd party to collect payment, potentially leading to damaged reputation.

Low Risk Assurance

Borrowing against money already owed to your business makes AR financing a low-risk option. Unlike relying on uncertain future sales, you're tapping into funds that are guaranteed. This significantly reduces the risk of not being able to repay the loan or line of credit, offering a more secure financial arrangement.

Disadvantages

Invoice Quality Matters

AR financing is less accommodating for businesses without a consistent flow of invoices and dependable customers. Qualifying for this type of financing may be challenging if your business lacks a steady invoicing process.

‍Eligibility

Generally, AR financing is a good solution if you have strong credit. But if not, you may not qualify. If however, you have a weaker credit history, an AR factoring company is more likely to accept your invoices.

Cost Considerations

The expenses associated with AR financing can pile up. Lenders may impose interest on the loan or line of credit, a funding fee based on the loan amount, and additional fees such as application, maintenance, and processing fees. These costs can accumulate quickly, impacting the overall affordability.

Customer Default Risks

There's a potential downside if your customers don't fulfil their invoice payments. In such cases, you might struggle to repay your loan or line of credit, exposing you to late payment charges and other financial difficulties. It's crucial to consider the risk of customer default when opting for AR financing.

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✅ Improve your cash flow?
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The B2B financing landscape

The truth of AR financing is that it’s been a method of freeing up working capital for years. But while AR financing companies can solve a range of cash flow issues, they don’t really solve the root of the problem. Businesses require AR financing because they’re being forced to wait for payment on their invoices.

So why do businesses put themselves in this position in the first place?

The reality is that offering trade credit as a payment method isn’t just a nice add on. It’s a necessity if businesses wish to continue to grow. And here’s why:

The value of B2B e-commerce is expected to reach $1.8 trillion by 2025. In fact, in 2021 manufacturers grew ecommerce by 18.4%. And with that comes a level of expectation from B2B buyers. Given 73% of all professional B2B purchasing decisions are made by millennials, the increasing assumption is that B2B companies will offer the same seamless purchasing experience as B2C.

Additionally, 82% would choose one vendor over others if that vendor offered invoicing at checkout with 30-, 60- or 90-day terms. When you consider that 90% of B2B buyers research payment options before purchasing from a new supplier, it’s obvious that payment via net terms is an expectation of buyers.

B2B Buy Now Pay Later - The modern accounts receivable financing

The demand for flexible B2B payments has driven substantial innovation in areas like embedded finance and automated payment reconciliation. For example, B2B buy now, pay later offers a simpler way of offering your business customers net terms with some considerable benefits including:

• Increased conversions rates, B2B sales, and average order value
• Drastically reduced admin time
• Offsetted credit and fraud risk
• Improved cash flow

Proactive, flexible, online financing

Traditional AR financing/factoring often falls short of providing timely and efficient access to working capital due to its manual and reactive nature. Businesses find themselves in a tough spot, compelled to either wait for funds until the invoice due date or sacrifice capital for quicker access to funds. This dilemma comes with the added burden of credit and default payment risks.

B2B BNPL offers a game-changing approach by providing the seller with upfront payments for sales on net terms, providing them with immediate cash flow benefits and eliminating the need for sellers to collect payments. Financial partners integrated into the B2B BNPL platform take care of settling the invoices themselves. This not only speeds up the process but also minimises credit and default risks for sellers.

Traditional receivable financing can also result in discrepancies between the credit risk assessed by the seller and the invoices the lender is willing to buy. For example, a seller may decide to offer trade credit to a buyer after running credit checks. At a later date, however, the seller may find it difficult to secure AR financing based on the creditworthiness of the customer, established by the financing company.

B2B BNPL addresses this issue by making credit decisions at the checkout, preventing post-sale hurdles.

Features like dynamic credit limits also make B2B BNPL a far more superior method of receivable financing. Customers access dynamic credit limits in real time based on their risk profile and what they can truly afford to borrow thanks to advanced credit engines baked into B2B BNPL platforms. These decisions also happen at the point of sale, not after, creating a far more streamlined invoice financing option.

Two - The highest net term credit limits for B2B. Instantly.

Two’s payment technology enables businesses across all industries to offer purchasing on invoice, providing a frictionless checkout experience with instantly approved credit. Our revolutionary B2B solutions simplify the payment journey so businesses can access working capital and increase B2B sales while reducing time consuming operational work.

Selling B2B with Buy Now, Pay Later can be incredibly complex. But it doesn’t have to be. With Two, you can increase conversion rates and average order value while eliminating admin and offsetting credit risk.

Whether you want to supercharge your B2B e-commerce checkout, optimise your trade account for frictionless customer onboarding, or offer B2B BNPL on all sales channels - Two is here to help.