Financing Accounts Receivables
Are you a small business owner looking for a reliable and flexible financing solution? Have you heard about financing your accounts receivable but are unsure about how it works and whether it’s the right fit for your business? In this article, we’ll help you understand this form of financing as an alternative to other types of business financing.
Financing Your Accounts Receivables
What exactly is accounts receivable financing? At its core, a business can use its accounts receivable in either two different ways to generate cash or working capital. One is to use the receivables as collateral for a loan. The other is to sell its receivables for cash.
The first type of A/R financing is called an accounts receivable asset based loan (ABL). ABL financing occurs when a borrower uses their total accounts receivable as collateral for a revolving line of credit, or a simple term loan. ABL’s are obtained from a bank or commercial lender.
The second type of A/R financing is called accounts receivable factoring (also referred to as invoice factoring or factoring finance). Factoring occurs when a business sells their individual accounts receivables, or invoices, to a third-party financial institution called a factoring company. The factoring company buys the invoices and pays the business an upfront percentage for each individual invoice. The factoring company then assumes the responsibility of collecting the unpaid invoices.
The factoring process is covered by an agreement with key details such as the advance rate, fee structure and other contractual obligations related to the sale of invoices.
Our focus in this article is accounts receivables factoring, since it’s our bread and butter at FactoringClub.
Assignment of your Accounts Receivables
Assignment (or selling) of receivables is the core component of the invoice factoring process. It’s the legal transfer of ownership from your business to the factoring company. Most often, factoring companies receive assignment of all your accounts receivable, even those that you don’t factor.
The factoring company issues a notice of assignment (NOA) to your customer(s) that informs them of the accounts receivables assignment. This allows the factoring company to directly collect payments from your customers.
It’s essential to understand that the assignment of invoices is not a practice of selling your customers’ information or trust. It’s a transparent process so your customers make payments to the correct entity, protecting you, the factoring company, and your clients.
Factoring is a Service, not a Loan
Contrary to common misconceptions, factoring is not a loan. It does not create any debt or encumber your business with liabilities. You’re not borrowing money, but strategically managing your cash flow by selling assets you already own. It’s a powerful financial tool designed to enhance your business’s growth and stability without the burdens often associated with traditional loans.
Factoring encompasses a broad range of services in addition to just paying advances on invoices. Factoring companies perform the following services:
- Verifying the accuracy of invoices
- Funding invoices in a timely manner
- Monitoring your customers’ credit
- Collecting payments from your customers
- Providing an accounting of factored invoices
Factoring services are, in essence, a partnership between a business and the factoring company dedicated to helping the business’s success.
Receivables Factoring Requirements
First, you need to operate a B2B (business-to-business) enterprise, as factoring is designed for trade credit transactions between businesses. Second your customers should have a strong credit history, as the factoring company relies on their financial stability to ensure payment. Lastly, your business should be free of liens and legal issues.
Getting Approved for Receivables Factoring
When it comes to getting approved for factoring, the process is usually straightforward and much more lenient than traditional bank financing. Factoring companies evaluate the following criteria for determining eligibility.
- Company owners: credit scores and background checks.
- Company: financial statements, accounts receivables balances and aging; liens and other debt or loans.
- Customers: credit score, credit terms, payment history, and overall financial health.
It is important to note that while these criteria are common, each factoring company has its own specific criteria for determining eligibility. Some lenders may place more emphasis on certain factors over others, depending on their risk appetite and industry focus.
In most cases, approval comes through in a matter of days or weeks. The process typically includes an application that outlines your personal credit, customers and outstanding balances, legal business details, and company liens or encumbrances.
Liens and UCC Filings
Navigating the complexities of business transactions requires meticulous attention to detail, especially when it comes to UCC (Uniform Commercial Code) filings and liens. The filing of a UCC lien is a standard requirement for many financial transactions, especially in factoring. A UCC lien provides a legal claim on assets in the event of a default on a loan.
One of the first things a factoring company will do when evaluating your business for factoring services is to perform a UCC search on your business. A UCC search provides critical information about any existing liens on assets that you may be intending to use as collateral. It serves as an essential tool for protecting the factoring company against unforeseen financial complications. By identifying any existing liens on your assets, the factoring company ensures that your financial transactions remain unencumbered and within legal bounds.
Once your business is cleared of any existing UCC filings, the factoring company will file its own UCC lien on your company’s receivables. The ultimate objective of the UCC search and filing process is for the factoring company to be in a first position on your accounts receivables.
A factoring agreement is a crucial and legally binding document that is integral to the success of your relationship with the factoring company. It outlines the specific terms and conditions under which the factoring transactions will be conducted, and it is vital, therefore, that you understand all its components thoroughly.
The agreement typically covers key details such as the advance rate, which refers to the percentage of the invoice amount that you will receive upfront, and the fee structure which determines the cost of the factoring service. It also includes terms like the length of the contract, invoice volume commitments, and the process for handling delinquent accounts.
Recourse vs Non-Recourse Factoring
The factoring agreement will specify who bears the risk of loss if a customer can’t pay an invoice. Recourse factoring, the more common and cost-effective of the two, places the burden of non-payment on the business. If an invoice isn’t paid within a pre-determined timeframe, the factoring company retains the right to sell the invoice back to you.
On the other hand, non-recourse factoring absolves you of the liability for bad debts. If a customer fails to pay the invoice for credit reasons such as insolvency or bankruptcy, the factoring company assumes the loss. It’s an attractive option, undoubtedly, but it comes at a premium. The factoring fees are higher to compensate for the increased risk taken on by the factor.
When to Finance Your Accounts Receivables
Accounts receivable financing (especially A/R factoring) can be a valuable tool in many scenarios, including:
- Cash Flow Challenges: If your business is experiencing cash flow gaps due to delayed payments from customers, factoring finance can provide immediate funds to bridge the gap.
- Seasonal Demand: Businesses that experience seasonal fluctuations in demand can use factoring finance to access working capital during the off-seasons.
- Rapid Growth: As your business expands, managing cash flow becomes critical. A/R finance can help fuel growth by providing the necessary funds to meet increasing operational demands.
Accounts receivable financing is much easier and more practical for small businesses than other traditional forms of business financing.
Application and approval don’t take long, so the owner isn’t spending lots of time away from the business. A business can get funded in a matter of days or weeks, not months.
Also, A/R financing is often a bridge to more traditional forms of financing, if the company reaches that level and determines other financing is more beneficial.
Ready to Start Factoring?
Ready to take control of your cash flow and start factoring your invoices? At FactoringClub, we understand accounts receivable factoring and we’re dedicated to guiding you through the process with ease.
Our expert team is committed to connecting you with the most suitable factoring partners, saving you from the time and hassle of choosing the right factoring company.
Don’t let the challenge of finding a factoring partner hold you back. Get started today and let FactoringClub help you find the perfect factoring company for your business.