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Evaluating the Accounts Receivable Financing Option

written by: Steve McFarlane•edited by: Jean Scheid•updated: 10/21/2010

What is accounts receivable financing and if your business is strapped for cash, should you consider AR financing? There are pros and cons to AR financing and here, we'll take a look at both.

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    Cash Is King

    AR Financing Having cash is critical and enables a business to finance the projects and operations that generate income and profits. This is even more the case when the cost of obtaining external financing is prohibitively high or lenders just aren’t lending. It is under these circumstances that a business must look to raising capital from sources other than its core activities. One finance option that businesses may consider is accounts receivable financing.

    Accounts receivable (AR) financing is the selling, to a third party, of amounts that are owed to a business by its customers and/or debtors. The lending agency will normally discount the receivables and offer the business the discounted sum in exchange for control of the cash flow from those receivables. How much the receivables are discounted will depend on the age of the receivables and how well they had being performing previously.

    All else being equal, an invoiced amount that has been outstanding for less then 30 days will be more valuable than an amount that has been outstanding for more than 6 months. In some cases receivables are used as collateral to secure a loan, while in other cases they can be sold outright by the business to get cash upfront. Where the AR is used as collateral, the business will use the cash flow from the receivables to repay the AR secured loan.

    Image Credit (Freedigitalphotos)

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    When to Use Accounts Receivables Financing

    One may ask why would anyone want to sell their receivables when they could possibly collect the full amount outstanding and avoid taking on debt and incurring financing charges. The short answer is, time is money. Not having free cash can seriously impair the efforts of a business to repay its own obligations to its creditors, employees and even make an income, but there are other reasons to consider accounts receivable financing; they include:

    • Outsourcing debt collections – Collecting on a debt may require the efforts of a professional debt collector especially when the debtor is playing hardball. In fact, the time and effort that may be involved in getting a debtor to repay may be higher than the amount the business is actually trying to collect.

      In such cases, it may be better to sell the debt to a professional debt collection agency and have them deal with it. But be warned, this can destroy the relationship with a customer. Most debtors consider the outstanding amount to be an issue that should be kept between themselves and the entity that they owe. If this is passed on to a third party they may not take it well, but then again, if they aren’t honoring their obligations, this concern shouldn’t be too big of an issue.
    • Quick access to financing – Being that accounts receivable is a near-cash asset, it is much easier to use it as collateral. As a result, using AR to secure a loan involves less bureaucracy.
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    Pitfalls to Using Accounts Receivable Financing

    When You Need Cash As stated previously, the AR will be discounted by a factor that the lender expects is sufficient to cover the risk they are undertaking and still make a profit. If the receivables are current and debtors are paying on time, the financier may charge a single digit discount rate such as 3.5% but that figure can be as high as 30% if the receivables are not performing. In such cases, accounts receivable financing can be quite expensive, especially compared to getting a bank loan. However, getting a bank loan may not be an option if the business is under stress and is near bankruptcy.

    Further, some third-party companies that do buy AR accounts, will not even look at receivables if they are over 30 days due, and these third party companies often only invest in AR financing if the receivables are high; so a company with $10,000 in receivables may not even qualify.

    Image Credit (Freedigitalphotos)

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    Using accounts receivable financing can really help a business to free up cash that is tied up in its receivables. Ideally businesses like to collect from their customers on time so that they can meet their own obligations, but it doesn’t always happen that way. In some cases, the business may have tied up its working capital by giving its debtors extended credit, while on the other hand customers may fail to pay in a timely manner. The net result is that cash flow may be insufficient to meet current obligations.

    It is in these cases that a business may consider using AR financing. It can be an expensive option because it immediately discounts the company’s asset base. Nevertheless, it is often an option that has to be strongly considered, especially when the survival of the business is dependent on getting adequate working capital quickly.