What Is Accounts Receivable Financing?

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Moreover, it has three major types, accounts receivable loans, factoring, and asset-backed securities (ABS). Borrowers must certainly pick AR financing during a cash crunch to gain some liquidity. Moreover, its benefits include a flexible structure, online services, no security requirements, and credit protection.

Key Takeaways

  • Accounts receivable financing meaning denotes a financial procedure wherein the company attains funds associated with a part of its AR. Furthermore, it helps companies collect capital on their outstanding invoices. The elements, including duration of receivables, documentation quality, the industry of the original account, and the debtor’s creditworthiness, certainly decide its quality. It has three major kinds: account receivable loans, factoring, and asset-backed securities. AR financing differs from factoring regarding collections, invoice value percentage, drawbacks, benefits, and accessing the value of outstanding invoices.

How Does Accounts Receivable Financing Work?

Accounts receivable financing denotes an agreement of a company’s short-term capitalization through its receivables. In addition, it assists in stabilizing the timing mismatch between the fund inflows and outflows of the firm. Therefore, the quality of receivables is central to financial decisions. 

Please note that the following elements determine the receivables’ quality, 

  • Duration of receivablesStandard of documentationBorrower’s creditworthinessThe original account’s industry

As per its meaning, accounts receivable financing companies use the agreement to assist small and large-scale businesses to avert cash flow issues and offer resources to attain business potential. Also, they advance an estimated amount of cash determined by the capital owed by the debtors for the services completed. 

Types Of Accounts Receivable Financing 

To clarify, there are three crucial types of accounts receivable financing agreement,

#1 – Accounts Receivable Loans

They are short-term financing sources wherein debtors might collateralize their accounts receivables to get money from the bank. Generally, the bank would loan out a portion of the receivables’ face value.

#2 – Factoring

It is certainly a funding mode wherein the business sells its AR to a third party (factor) at a discount to fulfill instant liquidity needs. Moreover, factoring is the most common method of AR financing for smaller enterprises.

#3 – Asset-backed securities

Please note that ABS are financial tools derived from and backed by the designated pool of underlying assets.

Examples

So, here are some examples to discern the accounts receivable financing meaning. 

To begin with, suppose that Andrew is a car merchant who sold five cars worth $35000 each to M/s Tefac INC. Although the latter guaranteed payment in three months, Andrew took up AR financing because of urgent money requirements.

Case 1 (a):

Taking the instance above, assume that Andrew got a 20% booking amount per car.

To clarify, fees disbursed to the financing company lessened from $25000 to $20000 since the account receivablesAccount ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more reduced too. Moreover, the fees are varying and are mainly in line with the underlying risk determined by the remaining amount, and creditworthiness of the buyer and principal debtor namely Tefac INC. 

Case 1 (b):

In this accounts receivable financing example, suppose Andrew obtains funding from the bank to save on fees. However, Andrew should pay the bank if Tefac INC dishonors the bill on the final date.

Financing from the bank will provide funds in Andrew’s bank account rather than cash.

Case 1(c):

So, let’s presume that Tefac INC dishonors the bank owing to inadequate capital. In such a situation, Andrew must settle the payment in three days. Moreover, he won’t get the repayment as fees paid to the bank are his loss.

Example #2

Here is another accounts receivable financing example. Suppose Jacob Importing Services Co. ordered Fernandez Exporters Ltd. to dispatch 10 containers worth $30,00,000 per month for a year. Furthermore, Jacob Importing Services promises full payment once the container reaches the port, i.e., 21 days.

Please note that the accounts receivable value for financing and bank fee is inversely proportional. In addition, this is because the transaction is inversely proportional to the default risk.

Case 2(a):

So, imagine that Fernandez Exporters asks for a Letter of creditLetter Of CreditA Letter of Credit (LC) is issued by a buyer’s bank to ensure timely, full payment to the seller. If the buyers default, the bank pays the sellers on their behalf.read more (LC) and offers the credit of 30-60 days to the buyer. So, it can directly book revenue and lower the price.

Please note that the buyer’s bank signs the LCLCThe full form of LC is a Letter of credit. A letter of credit is a document issued by the buyer’s bank, known as the issuing bank, that guarantees that the buyer will pay the correct amount to the seller on time, and that if the buyer fails to pay the amount to the seller, the bank is liable to pay the outstanding dues to the seller on behalf of the buyer.read more, and such negotiations are solely valid for import-export business.

To clarify, bank fees depend on Fernandez Exporters’ former credit score. If the credit score is below the bank accepting limits, it will receive higher fees regardless of high-value transactions.

Accounts Receivable Financing Vs Factoring

This article has been a Guide to Accounts Receivable Financing & its meaning. Here we explain accounts receivable financing agreement vs factoring and its examples. Here are the other articles in accounting that you may like –

The accounts receivable financing agreement certainly leverages its AR to gain cash on pending invoices.On the other hand, factoring is a funding method involving the sale of AR by a business to a third party at a discounted rate to meet its immediate liquidity needs.

No, accounts receivable financing is not a loan. Having said that, one of the AR financing types is AR loans. It is considered better than a loan due to non-mandatory collaterals. In addition, it does not have rigid eligibility criteria concerning business turnover and other elements.

Accounts receivable financing is important for small businesses as it helps them modify capital inflow, purchase the latest equipment, recruit additional personnel, and develop cash reserves. Moreover, it is a quick and convenient approach for small and mid-sized firms to raise funds.

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