Of course, accounts receivable financing, also referred to as invoice financing, isn’t without downsides. For one thing, it can result in excessive fees that your business may not be able to afford. Still, accounts receivable financing can be a very useful tool for the right small business owner at the right time. To help you decide if you should pursue it, we'll first define accounts receivable financing. Then, we’ll cover how to apply for accounts receivable financing, its most notable pros and cons, and popular financing alternatives.
What is Accounts Receivable Financing?Accounts receivable financing is an agreement in which a business borrows money based on the quality and quantity of its accounts receivables. It’s also called invoice financing because “accounts receivable” refers to the outstanding invoices a company has.
Accounts Receivable Financing vs. FactoringThere are two ways accounts receivable financing may be structured. The first is called invoice (or accounts receivable) financing and the second is invoice (or accounts receivable) “factoring.” With invoice factoring, you sell your outstanding invoices to a factoring company for a cash advance. Then, when your customers pay, you receive the balance of the invoice minus a factoring fee. The company you sell your invoices to directly collects your invoice payments. With invoice financing, you use your invoices as collateral for a line of credit. As with a traditional line of credit, you can draw funds (up to a predetermined limit) at any time. In contrast to factoring, with invoice financing, you’re still responsible for collecting payments.
The Pros of Accounts Receivable Financing
1. Fast fundingRegardless of how you structure it, accounts receivable financing is one of the quickest ways to access additional working capital. Depending on the financing lender you select, you may receive your money in as little as 24 hours. This speed of funding makes invoice financing a great option to solve short-term cash flow problems.
2. Minimal credit requirementsWith invoice financing or factoring, what the financing company cares most about is the quality of your invoices. If your customers have good credit and pay on time, your credit score isn’t a deciding factor. This is because your invoices serve as collateral, and for the lender, the downside risk is that your customers don’t pay. Therefore, if you can show that you have reliable customers, you can obtain invoice financing without a stellar credit history.
3. Ability to outsource collectionAs mentioned above, when you use invoice factoring, the factoring company takes over payment collection. For many entrepreneurs, this takes a large administrative burden off their plate. However, keep in mind that this is only the case for invoice factoring. With invoice financing, you’ll still be expected to collect invoice payments.
The Cons of Accounts Receivable Financing
1. Can Be CostlyFee structures for accounts receivable financing can get complicated, and expensive, fast. The rate you pay depends on:
- The quantity of and average invoice amount
- Your company’s industry
- Your customers’ creditworthiness and payment history
2. Lack of controlWhile some entrepreneurs enjoy outsourcing payment collection to factoring companies, others may bristle at the loss of control. After all, collecting payment is an important—and sometimes sensitive—part of your customer’s experience. If you choose to factor your invoices, you lose all control over this integral part of your customers’ interaction with your brand
3. Dependency on customersOne of the greatest benefits and flaws of invoice financing is its dependency on your customers. On the one hand, your chances of being approved aren’t as dependent on your credit history as other types of financing. On the other, if your customers have poor credit scores or a checkered payment history, approval can be an issue. Plus, if you manage to get approved, you’ll pay a higher factoring fee. On top of that higher baseline fee, you may be charged even more if your customers pay late.
How to Apply for Account Receivable FinancingTo apply for accounts receivable financing or factoring, you need to complete an application. You’ll also be asked for bank account statements and accounting documents that show your expected income. Once you’re approved, you then submit unpaid invoices. After that, the factoring company will approve your invoices and open your line of credit, or pay you an advance.
Conclusion: Weigh Your Financing AlternativesInvoice financing is ideal for borrowers with poor credit histories and reliable customers who need short-term funding. Still, it's not the right business funding option for everyone. For one, it only works if you use invoices to collect payment. Plus, it can get very expensive if your customers fail to pay their bills on-time. Due to the reasons outlined in this post, it's smart to consider other financing alternatives. Some popular short-term funding alternatives include:
- Small Business Loans (Specifically Microloans)
- Business lines of credit
- Business credit cards
- Equipment financing
- Inventory loans