2 Methods of Accounts Receivable Financing
Accounts receivable financing can be used as an alternative to bank financing. Commercial finance companies often offer accounts receivable financing to small businesses. 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 and factoring.
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 customers. A lender looks at the aging schedule of your 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, it will decide what percentage of the value of the acceptable receivables it will loan and make the loan to your small business. The percentage it will loan is usually around 75% or 85%.
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% to 90% of the total value of the receivables. After charging a small fee to the company, usually 2% or 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 the risk of default by the customer. 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 may not be acceptable financing, however, for longer-term business financing needs.
