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What is Receivables Financing: A Comprehensive Guide

By Athena Rebello

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Updated on: Sep 1st, 2023

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7 min read

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Accounts receivable (AR) finance gives companies of all sizes the resources they need to accomplish commercial growth while assisting them in avoiding cash flow issues. Essentially, a lender advances a portion of an organisation's outstanding invoices in the form of a loan or line of credit, with the accounts receivable serving as collateral.

Read along as we go in-depth about receivable financing, its benefits, and drawbacks, and explain how it works with examples.

What Is Receivable Financing?

Receivables financing—or trade receivables financing—is a short-term funding option that lets businesses borrow money against the value of their accounts receivables. Accounts receivable are invoices issued to debtors that have not yet been paid.

Receivables financing enables firms to enhance their cash flows and maintain operations without interruption by gaining access to locked-up funds.

To put it simply, a company that uses accounts receivable financing sells some or all of its outstanding customer invoices to a third party known as the funder or financier.

Although there may be some costs associated, receivables financing boosts a company’s working capital, which it can use for expansion.

Benefits and Drawbacks Of Receivables Financing

Using accounts receivable financing to fund your company’s growth has various benefits, such as:

  • Enhanced cash flows: Accounts receivable financing enables firms to receive payment for bills instantly rather than having to wait for their customers to pay, thereby enhancing their cash flows.
  • Zero debt: Accounts receivable finance is not considered debt because the company sells its invoices instead of borrowing money. Therefore, owners do not need to worry about paying interest. 
  • No collateral: The financing company doesn’t require any assets as collateral since the invoices themselves represent a guarantee. This means that no business or personal assets are at risk.

Just like every good thing, receivable financing comes with drawbacks, too, including:

  • It is an expensive method: The lending company usually charges a percentage of the receivables amount as fees. This fee is often higher than the interest rates on loans, making the process expensive.
  • There is a risk of default: The finance company might not be able to get their money back if a customer defaults on their payments. 
  • There is a lack of control: By selling its receivables, a business gives up control over how the money is collected. This can be troublesome if the finance company is unable to collect money from customers as rapidly as the business would like.

How Does Receivables Financing Work?

Accounts receivable financing works by obtaining a loan from a lender using an enterprise’s outstanding customer invoices as collateral. The lender advances a portion of the invoice value. When the customer repays the invoice, the enterprise receives the remaining balance minus the lender's fee. The lender's fee can depend on various factors, including the length of the contract. 

Here’s a step-by-step guide on how receivables financing works:

  • An enterprise applies and secures funding from the financial institution against their accounts receivables
  • The financial institution verifies the authenticity of the invoices and provides a funding offer
  • The enterprise receives the funds and uses them for its business as required
  • The financial institution collects the invoice payments from the customer on the due date and remits the balance amount to the enterprise, if any, after deducting their fees

Example Of Receivable Financing

ABC Enterprises sells automobile parts and they receive a large purchase order from a car company called DXV Ltd.

DXV Ltd. is willing to buy equipment worth INR 200,000 but can only make the payment two months later. ABC Enterprises accepts the terms, delivers the equipment, and issues an invoice of INR 200,000 due 60 days later.

Now, ABC Enterprises applies for receivables financing, and after due consideration, the financier—XYZ Finance, approves the application. They advance INR 150,000 to ABC Enterprises.

This leads to the following conditions:

  • DXV Ltd. gets the equipment it needs and gets to pay for the same at a later date.
  • ABC Enterprises gets access to cash immediately.
  • XYZ Finance profits from the financing fees.

Frequently Asked Questions

Why is receivables financing important for small businesses?

Small businesses need accounts receivable finance because it reduces financial strain by enabling them to turn their receivable invoices into cash. They get instant access to funds, which could normally take months.

What are the four forms of receivables financing?

Factoring, accounts receivable loans, asset-based lending, and purchase order financing are the four forms of receivable financing.

What is the difference between accounts receivable and receivables financing?

The basic difference between accounts receivable and receivables financing is that accounts receivables is the money your debtors owe you. Whereas receivables financing is the steps you take to get money against your accounts receivables. 

 

About the Author

A Chartered Accountant by profession and a writer by passion, my expertise extends to creating insightful content on topics such as GST, accounts payable, and invoice discounting.. Read more

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