What is accounts receivable financing?

Published 17th April, 2023

Accounts receivable financing is a method of short-term funding that allows businesses to borrow capital against the value of their accounts receivables. 

Also known as trade receivables financing or AR financing, accounts receivable financing allows businesses to improve their cash flow and continue operations uninterrupted by accessing tied up capital.

Table of contents

1. How does accounts receivable financing work?
2. Types of accounts receivable financing
3. Accounts receivable financing vs accounts receivable factoring
4. Accounts receivable financing advantages and disadvantages
5. The B2B financing landscape
6. B2B Buy Now Pay Later - The modern accounts receivable financing

‍‍How does accounts receivable financing work?

With accounts receivable financing, a lender advances you a percentage of the value of your receivables - as much as 90%. Once your customer pays their invoice, you receive the remaining balance minus a lender’s fee.

Lender’s fees can vary depending on the financing company but generally they’re between 1-5%. Bear in mind though, that the amount you pay in fees is based on how long it takes your customer to pay their invoice. The longer they take, the more expensive it is for you.

Key points:

• Your unpaid invoices are used as collateral to secure a loan
• You still assume responsibility for collecting payment

Here’s what the process of accounts receivable financing looks like:

1. Apply and secure financing: Let's say you have a €20,000 invoice with 30-day payment terms. After submitting your application, the lender approves you for an advance of 80% (€16,000) on the invoice amount.
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2. Secure financing: You can then use the funds as you wish to run your business. The lender will charge you an agreed fee, which could be per day or per week, depending on the agreement. For example, if the fee is 3% per week, the lender would charge you €600 (3% of €20,000) for every week it takes your customer to pay the invoice.
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3. ‍Payment collection from your customer: Your customer pays their invoice after 3 weeks. You then owe the lender a fee of €1,800 (3% of the total invoice amount per week for 3 weeks).
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4. ‍Repayment to the lender: After receiving payment from your customer, you have €4,600 left, which you can keep. You then repay the lender the original advance amount plus fees, which amounts to €17,800.

To understand the true cost of invoice financing, it's important to consider the lender fees as an annual percentage rate. In this example, the approximate annual percentage rate would be 62.4% (based on a 3% weekly fee for 3 weeks on the total invoice amount of €20,000).

Types of accounts receivable financing

There are various types of accounts receivable financing available to businesses, providing immediate cash flow by utilising outstanding invoices or accounts receivable. Here are some common options:

1. Factoring: In this method, businesses sell their accounts receivable to a financial institution, known as a factor, at a discounted rate. The factor takes responsibility for collecting payments from customers, while the business receives an upfront cash advance based on the discounted invoice value.
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2. Asset-Based Lending (ABL): ABL involves using accounts receivable as collateral for obtaining a line of credit. Lenders extend a percentage of the eligible receivables, allowing businesses to draw funds as needed and pay interest on the borrowed amount.
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3. Invoice Discounting: Similar to factoring, invoice discounting lets businesses retain control over collections. In this case, invoices are used as collateral for a loan, and businesses receive a percentage of the invoice value upfront. Repayment, including fees and interest, occurs once the customer pays the invoice.
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4. Supply Chain Finance: Also known as reverse factoring, supply chain finance involves collaboration between buyers, suppliers, and financing institutions. Buyers' financial institutions provide early payment to suppliers for approved invoices, often at a discount. Later, buyers repay the financial institution.

Accounts receivable financing vs accounts receivable factoring

Although these two terms are sometimes used interchangeably, AR financing and AR factoring are two different things.

AR factoring (also known as debt factoring) also uses your unpaid invoices as collateral to secure the loan. But it involves selling your outstanding receivables at a discount. The factoring company then pays you a percentage of the invoice value and collects payment directly from your customer.

Once your customer settles their invoice, the factoring company then gives you the rest of the money minus their factoring fees. Typical invoice factoring rates are between 1% and 6%. But factoring companies can charge hidden fees on top of this:

ACH fee: This fee is charged by the factor's bank for wiring funds to your account. Sometimes this is called a wire fee.

‍Application fee: This fee can be a flat or percentage fee and may differ from one factoring company to another.

Invoice processing fee: This is charged for getting your unpaid invoices processed in the back office.

Closing fee: This is an extra amount that the factoring company keeps from the invoice.

Monthly fee: If you sign a contract that requires you to sell a certain percentage of your invoices each month, you could end up paying a monthly fee if you don't meet the minimum.

Termination fee: If you sign a factoring agreement or long-term contract and want to end it early, you may be charged a termination fee.

Read more about debt factoring.

Off-balance sheet financing

Accounts receivable represents a considerable liability for many businesses as the possibility of default payments is high. To counteract this, many businesses sell their unpaid invoices to a factoring company to avoid listing this high-risk asset on their own balance sheet. This is known as off-balance sheet financing.

In just a moment, we’ll look at the issues with doing this. But to quickly explain, this method is very reactive, forcing the business to make a decision after the sale instead of before.

Accounts receivable financing advantages and disadvantages

So what makes a business choose one type of accounts receivable financing over another? To understand this in more details, here are some advantages and disadvantages of accounts receivable financing:

Accounts receivable financing advantages

Ownership of invoices: When you receive AR financing, you retain ownership of your unpaid invoices. So although you are still responsible for collecting payment, you’re able to maintain your relationships with your customers. In this instance, your customers won’t be contacted by a 3rd party to collect payment, potentially leading to damaged reputation.

Cost: AR financing tends to be less expensive than AR factoring because you’re still assuming more of the risk. Most of the cost associated with AR factoring comes from factoring fees as a result of assumed risk by the factoring company.

Accounts receivable financing disadvantages

Eligibility: Generally, AR financing is a good solution if you have strong credit. But if not, you may not qualify. If however, you have a weaker credit history, an AR factoring company is more likely to accept your invoices.

Risk: While AR financing ultimately gives you more control, you still assume the risk for unpaid invoices. And that means you’re still liable for undesirable outcomes should your customers not pay on time.

The B2B financing landscape

The truth of AR financing is that it’s been a method of freeing up working capital for years. But while AR financing companies can solve a range of cash flow issues, they don’t really solve the root of the problem. Businesses require AR financing because they’re being forced to wait for payment on their invoices.

So why do businesses put themselves in this position in the first place?

The reality is that offering trade credit as a payment method isn’t just a nice add on. It’s a necessity if businesses wish to continue to grow. And here’s why:

The value of B2B e-commerce is expected to reach $1.8 trillion by 2025. In fact, in 2021 manufacturers grew ecommerce by 18.4%. And with that comes a level of expectation from B2B buyers. Given 73% of all professional B2B purchasing decisions are made by millennials, the increasing assumption is that B2B companies will offer the same seamless purchasing experience as B2C.

Additionally, 82% would choose one vendor over others if that vendor offered invoicing at checkout with 30-, 60- or 90-day terms. When you consider that 90% of B2B buyers research payment options before purchasing from a new supplier, it’s obvious that payment via net terms is an expectation.

B2B Buy Now Pay Later - The modern accounts receivable financing

The demand for flexible B2B payments has driven substantial innovation in areas like embedded finance and automated payment reconciliation. For example, B2B buy now, pay later offers a simpler way of offering your business customers net terms with some considerable benefits including:

• Increased conversions rates, B2B sales, and average order value
• Drastically reduced admin time
• Offsetted credit and fraud risk
• Improved cash flow

Proactive, flexible, online financing

One of the major drawbacks of traditional AR financing/factoring is that it’s very manual and reactive. Businesses need receivable financing to access tied up working capital thanks to how traditional trade credit works. 

The very concept of selling on net terms means businesses are stuck between a rock and a hard place. Wait until the invoice due date to receive their funds or sacrifice capital to access it sooner. All while being liable for the associated credit and default payment risks.

B2B Buy Now Pay Later solves this by paying businesses upfront for their sold invoices. Payments don’t need to be collected by the seller as integrated financial partners pay for the invoices sold through the B2B BNPL platform.

Traditional receivable financing options can also lead to discrepancies between the credit risk established by the seller and what invoices the lender is willing to buy. For example, a seller may decide to offer trade credit to a buyer after running credit checks. 

However, when the seller tries to finance the customer’s unpaid invoice, the lender may decide the risk is too high, preventing the seller from financing their due invoices.

B2B BNPL, on the other hand, makes the credit decision at the checkout instead of after the sale.

Features like dynamic credit limits also make B2B BNPL a far more superior method of receivable financing. Customers access dynamic credit limits in real time based on their risk profile and what they can truly afford to borrow thanks to advanced credit engines baked into B2B BNPL platforms. These decisions also happen at the point of sale, not after, creating a far more streamlined invoice financing option.

Two - The complete B2B payment suite

Two’s payment technology enables businesses across all industries to offer purchasing on invoice, providing a frictionless checkout experience with instantly approved credit. Our revolutionary B2B solutions simplify the payment journey so businesses can access working capital and increase B2B sales while reducing time consuming operational work.

Selling B2B with Buy Now, Pay Later can be incredibly complex. But it doesn’t have to be. With Two’s B2B payment suite, you can increase conversion rates and average order value while eliminating admin and offsetting credit risk.

Whether you want to supercharge your B2B e-commerce checkout, optimise your trade account for frictionless customer onboarding, or offer B2B BNPL on all sales channels - Two is here to help.