Accounts Receivable Financing

What is 'Accounts Receivable Financing'

Accounts receivable financing is a type of asset-financing arrangement in which a company uses its receivables — outstanding invoices or money owed by customers — as collateral in a financing agreement. In this agreement, an accounts receivables financing company, also called a factoring company, gives the original company an amount equal to a reduced value of the unpaid invoices or receivables.

This type of financing helps companies free up capital that is stuck in unpaid debts. Accounts receivable financing also transfers the default risk associated with the accounts receivables to the financing company.

BREAKING DOWN 'Accounts Receivable Financing'

Accounts receivables financing companies typically advance companies 70 to 90% of the value of their outstanding invoices. Then, the factoring company collects the debts and pays the original company the remainder of the amount collected minus a factoring fee.

How Factoring Companies Price Accounts Receivables

Factoring companies take several elements into account when determining how much to offer a company in exchange for its accounts receivables. In most cases, accounts receivables owed by large companies or corporations are more valuable than invoices owed by small companies or individuals. Similarly, new invoices are more valuable than old invoices. Generally, the easier the factoring company feels a bill is to collect, the more valuable it is, and the harder a bill is to collect, the less it is worth.

How Accounts Receivable Financing Helps Companies

This type of asset-based financing allows companies to get instant access to working capital without jumping through the hoops or dealing with the lengthy waits associated with getting a business loan. When a business leverages its accounts receivables to boost its cash flow, it also doesn't have to worry about repayment schedules, and instead of focusing on trying to collect bills, it can focus attention on other core aspects of its business.

In addition to providing a unique financing option for businesses, factoring companies also offer other services. These accounting-centered services include running credit checks on new clients and generating financial reports.

Negative Perceptions Associated With Factoring

Although factoring offers a number of diverse advantages, it sometimes carries negative connotations. In particular, financing through factoring companies typically costs more than financing through traditional lenders such as banks. As a result, businesses who turn to factoring companies are sometimes perceived to have poor credit or to being failing financially in other ways. However, analysts in the industry claim these misgivings are not founded on reality, and they state all manner of upwardly mobile, successful companies use accounts receivables financing as needed.

Accounts receivable refers to the outstanding invoices a company has or the money the company is owed from its clients. The phrase refers to accounts a business has a right to receive because it has delivered a product or service. Receivables essentially represent a line of credit extended by a company and due within a relatively short time period, ranging from a few days to a year.

BREAKING DOWN 'Accounts Receivable - AR'

On a public company's balance sheet, accounts receivable is often recorded as an asset, because there is a legal obligation for the customer to remit cash for the debt. If a company has receivables, this means it has made a sale but has yet to collect the money from the purchaser. Essentially, the company has accepted an IOU from its client.

Why Do Businesses Have Accounts Receivable?

Most companies operate by allowing some portion of their sales to be on credit. In some cases, business offer this type of credit to frequent or special customers who are invoiced periodically. The practice allows customers to avoid the hassle of physically making payments as each transaction occurs. In other cases, businesses routinely offer all of their clients the ability to pay after receiving the service. For example, electric companies typically bill their clients after the clients have received the electricity. While the electricity company waits for its customers to pay their bills, the unpaid invoices are considered accounts receivable.

A way for businesses to borrow money based on amounts due from customers. Invoice financing helps businesses improve cash flow, pay employees and suppliers, and reinvest in operations and growth earlier than they could if they had to wait until their customers paid them. Businesses pay a percentage of the invoice amount to the lender as a fee for borrowing the money. Invoice financing can solve problems associated with customers taking a long time to pay and difficulties obtaining other types of business credit.

BREAKING DOWN 'Invoice Financing'

Invoice financing also benefits lenders because unlike extending a line of credit, which is unsecured and leaves little recourse if the business doesn’t repay what it borrows, invoices act as collateral for invoice financing. The lender also limits its risk by not advancing 100% of the invoice amount to the borrowing business. Invoice financing doesn’t eliminate all risk, though, since the customer might never pay the invoice, which could result in a difficult and expensive collections process.

Factor

A factor is a financial intermediary that purchases receivables from a company. A factor is essentially a funding source that agrees to pay the company the value of the invoice less a discount for commission and fees. The factor advances most of the invoiced amount to the company immediately and the balance upon receipt of funds from the invoiced party.

BREAKING DOWN 'Factor'

A factor allows a business to obtain immediate capital based on the future income attributed to a particular amount due on an account receivable or business invoice. Accounts receivable function as a record of the credit extended to another party where payment is still due. Factoring allows other interested parties to purchase the funds due at a discounted price in exchange for providing cash up front.

Factoring Operations

The terms and conditions set forth by a factor may vary depending on their own internal practices. Most commonly, factoring is performed through third party financial institutions, referred to as factors. Factors often release funds associated with newly purchased accounts receivable within 24 hours. Repayment terms can vary in length depending on the amount involved. Additionally, the percentage of funds provided for the particular account receivables, referred to as the advance rate, can also vary.

Accounts Receivable Aging

Accounts receivable aging is a periodic report that categorizes a company's accounts receivable according to the length of time an invoice has been outstanding. It is used as a gauge to determine the financial health of a company's customers. If an accounts receivable aging demonstrates that a company's receivables are being collected much slower than normal, this is a warning sign that business may be slowing down or that the company is taking greater credit risk in its sales practices.

BREAKING DOWN 'Accounts Receivable Aging'

As a management tool, accounts receivable aging may indicate that certain customers are not good credit risks, and may reveal whether the company should keep doing business with customers that are chronically late payers.
Accounts receivable aging is typically broken into date ranges of 30 days. The report typically reports total receivables that are currently due, as well as receivables that are past due.

Invoice

An invoice is a commercial document that itemizes a transaction between a buyer and a seller. If goods or services were purchased on credit, the invoice usually specifies the terms of the deal, and provide information on the available methods of payment. An invoice is also known as a bill or sales invoice.

BREAKING DOWN 'Invoice'

Companies may opt to simply send a month-end statement as the invoice for all outstanding transactions. If this is the case, the statement must indicate that no subsequent invoices will be sent.
An invoice must state it is an invoice on the face of the bill. It typically has a unique identifier called the invoice number that is useful for internal and external reference. An invoice typically contains contact information for the seller or service provider in case there is an error relating to the billing. Payment terms may be outlined on the invoice, as well as the information relating to any discounts, early payment details or finance charges assessed for late payments. It also presents the unit cost of an item, total units purchased, freight, handling, shipping and associated tax charges, and it outlines the total amount owed.

Aging

Aging is a method used by accountants and investors to evaluate and identify any irregularities within a company's accounts receivables. Aging is achieved by sorting and inspecting the accounts according to their length outstanding. By aging a company's accounts receivables, a person can get a better view of a company's bad debt and financial health.

BREAKING DOWN 'Aging'

An accounts receivable (AR) aging report lists unpaid customer invoices and credit memos by date ranges to determine which invoices are overdue. A typical report lists invoices in 30-day groups, such as 30 days old, 31-60 days old and 61-90 days old. The aging report is sorted by customer name and itemizes each invoice by number or date.

Receivables

Receivables is an asset designation applicable to all debts, unsettled transactions or other monetary obligations owed to a company by its debtors or customers. Receivables are recorded by a company's accountants and reported on the balance sheet, and they include all debts owed to the company, even if the debts are not currently due. Long-term receivables, which do not come due for a significant length of time, are recorded as long-term assets on the balance sheet; most short-term receivables are considered part of a company's current assets.

BREAKING DOWN 'Receivables'

Receivables, also referred to as accounts receivables, are created for customers through the use of credit. Some customers are given 15 days to pay while others are given a year or more. As the account ages, the likelihood of converting the receivable into cash decreases. Once a company believes a receivable is not going to be paid, it can transfer the account to a contra account called the allowance for doubtful accounts. The allowance is based on the number of receivables that did not pay from the previous period.

Net receivables

Net receivables is the total money owed to a company by its customers minus the money owed that will likely never be paid. Net receivables is often expressed as a percentage, and a higher percentage indicates a business has a greater ability to collect from its customers. For example, If a company estimates that 2% of its sales are never going to be paid, net receivables equal 98% (100% - 2%) of the accounts receivable.

BREAKING DOWN 'Net Receivables'
Net receivables is used to measure the effectiveness of a company's collection process and is utilized in cash forecasts to project anticipated cash inflows. Net receivables arise due to the granting of credit. This carried inherent credit and default risk as the business does not receive payment upfront. Cash collections can be improved by tightening control over credit issued to customers, maintaining efficient collection procedures and performing collection procedures in a timely manner.

Allowance for Doubtful Accounts

The allowance for doubtful accounts is subtracted from the gross amount of outstanding accounts receivables. The two main methods of estimating the allowance for doubtful accounts is the net receivable method or net sales method. In addition, a specific identification method may be used in which each debt is individually evaluated regarding the likelihood of being collected.

Aging Schedule

An aging schedule is an accounting table that shows the relationship between a company’s bills and invoices and its due dates. Often created by accounting software, aging schedules can be produced for both accounts payable and accounts receivable to help a company see whether it is current on its payments to others and whether its customers are paying it on time.

BREAKING DOWN 'Aging Schedule'

An aging schedule often categorizes accounts as current (under 30 days), 1-30 days past due, 30-60 days past due, 60-90 days past due, and more than 90 days past due. Companies can use aging schedules to see which bills it is overdue on paying and which customers it needs to send payment reminders to or, if they are too far behind, send to collections. A company wants as many of its accounts to be as current as possible. A company may be in trouble if it has a significant number of past-due accounts.

Aging schedules can help companies predict their cash flow by classifying pending liabilities by due date from earliest to latest and by classifying anticipated income by the number of days since invoices were sent out. Besides their internal uses, aging schedules may also be used by creditors in evaluating whether to lend a company money. In addition, auditors may use aging schedules in evaluating the value of a firm’s receivables.

If the same customers repeatedly show up as past due in an accounts receivable aging schedule, the company may need to re-evaluate whether to continue doing business with them. An accounts receivable aging schedule can also be used to estimate the dollar amount or percentage of receivables that are probably uncollectible.

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Source: http://docphy.com/business-industry/banking/accounts-receivable-financing.html