Using your accounts receivable, or your customers’ credit accounts, to obtain financing for your small business, is another method of raising money for working capital needs. Both accounts receivable financing and inventory financing are usually used for quick, short-term loans when it is not possible to obtain a short-term loan from a bank or other financial institution. Both are used to raise working capital or the money you use for your daily operations.
Accounts receivable financing or factoring can also be used as an alternative to bank financing.
Commercial finance companies often offer accounts receivable financing to small business firms. Sometimes, commercial banks or other financial institutions will also offer accounts receivable financing. Interest rates are usually higher on this type of financing than on a traditional bank loan.
There are two methods of accounts receivable financing.
Pledging Accounts Receivable
Pledging, or assigning, accounts receivable means that you essentially use your accounts receivable as collateral to obtain cash. The lender has the receivables as security, but you, as the business owner, are still responsible for the collection of the debts from your credit customers.
A lender looks at the aging schedule of a business firm’s accounts receivables in determining which ones to accept as collateral. Usually, the lender only accepts those receivables that are not overdue. Overdue accounts don’t make good collateral. Also, if a customer has credit terms extended to them that the lender thinks are too long, the lender may not accept those particular receivables either. After examining a company’s receivables for overdue accounts and terms the lender doesn’t like, the lender then determines what amount of the company’s receivables they will accept.
After that, the lender will typically adjust that amount for returns and allowances. At that point, they will decide what percentage of the value of the acceptable receivables they will loan and make the loan to the small business. The percentage they will loan is usually around 75-85%.
Here's an example of how a lender evaluates a small business firm's accounts receivables to determine how much of a loan they will make.
If the small business defaults on the loan, the lender then takes over the company’s accounts receivables and collects on the debts themselves.
Factoring Accounts Receivable
Factoring your accounts receivables means that you actually sell them, as opposed to pledging them as collateral, to a factoring company. The factoring company gives you an advance payment for accounts you would have to wait on for payment. The advance payment is usually 70-90% of the total value of the receivables. After charging a small fee to the company, usually 2-3%, the remaining balance is paid after the full balance is paid to the factor.
Factoring is a relatively expensive source of financing, but the cost is lowered because the factoring company takes on all risk of default by the customer.
Factoring is important in the retail industry in the U.S. In fact, the garment industry accounts for about 80% of all U.S. factoring, although many small businesses in a huge variety of industries use this form of financing when they need short-term working capital loans.
Sometimes, using accounts receivable financing is all that stands between your small business and bankruptcy, particularly during a recession or other types of tough times for your business. Don’t hesitate to use it for your working capital needs if you need to. It is not acceptable financing, however, for longer term business financing needs.