The benefits of accounts receivable financing for businesses can be hard to resist. The system offers the lure of getting immediate financing to enhance business growth.
Pros and Cons of Accounts Receivable Financing
Pros Explained
No need for collateral: It is a type of unsecured business financing option that does not require any collateral in the form of assets and guarantors.Retain ownership of your business: This type of financing does not require you to give out part of your business ownership to acquire finances.Fast financing: Factoring companies can typically advance an invoice within 24 hours of submitting.
Cons Explained
Higher costs: While it is a quick way of accessing cash for your business, it may come at higher costs than the rates charged on other types of business loans. Remember that failure to pay back the amount within the predetermined period will only increase the total amount that you will be required to pay.Lengthy contracts: Some agreements can be short and viable, but others can be more long and winding than you would like. It is crucial, however, to negotiate the length of the contract that perfectly works for you and your business.Debtor may not pay: The person or company who owes you money may not pay the factoring company, which may mean you’re on the hook for what they should’ve paid.
How AR Financing Works
AR financing can take various forms. The business owner using this method must understand if their agreement is structured as a loan or as a sell of assets. Accounts receivable are unpaid and outstanding bills that are due to a business. On a balance sheet, these items fall into the category of a current asset and are seen as one of a company’s liquid assets. Liquid assets are those possessions that can be turned into cash easily,
Asset Sell
Most of this type of financing takes the form of a selling company assets. Here, the due accounts are sold to another company in return for cash. The lender will usually pay only a portion of the total AR value to the business. Once sold, the lender assumes the responsibility of collecting the debt.
Loan and Collateral
When your AR financing is structured as a loan, the AR book is seen as collateral to the loan. The company retains the ownership of the AR book and the duty to collect on those debts. Business owners should ensure that the deal has a prime rate, which in essence is the varied interest amount. They should find out how the prime rate is calculated and whether it is tied to the factoring. Keep in mind that a prime rate is an essential part of accounts receivable financing.
Dating the Invoice
The purchase date is another element of the agreement that you must put into perspective. In normal cases, invoices are payable within more than 90 days. Factoring companies may prefer invoices that are newer and have a longer collection shelf-life than those that are near-term or delinquent.
Length of the Agreement
The length of the AR financing agreement is important for the business to consider. Whether the AR agreement goes for months, a year or several years can have varying impacts on a company. Be sure that you are well aware of the length of the agreement, and whether a short-term or long-term agreement will be vital for your business.
Full Recourse, Reserve Accounts, and Reserve Amounts
Some AR financing may include a full recourse clause. Under this provision, the lender can force the business to pay any invoices that are uncollectable after a specified period. Some agreements allow the factoring companies to take a percentage of the paid invoices and place those funds into a reserve account. The reserve account will help to cover any uncollectable invoices. Finally, contracts may contain a reserve amount condition. This clause allows the factoring company to withhold some of the finance funds until invoices are paid.
