Accounts Receivable Financing Explained in Simple Terms

In its simplest definition, accounts receivable financing is the trading of what your customers owe you in the future for cash you receive today.

How is that possible? It is possible because there are accounts receivable financing companies that are in the business of lending you money in exchange for the money you are owed by your customers. They pay you less than what you are owed, therefore profiting from the difference.

Here is how it works:

  1. Customer A owes you $1,000 30 days from now.
  2. Company B tells you to sell the accounts receivable of $1,000 to them for $990.
  3. You agree and transfer the rights to collect on the $1,000 to Company B in exchange for a $990 payment you receive today.

What happens as a result of all this? Customer A still owes $1,000, except they don’t pay you. They pay Company B instead. Company B paid you $990 in exchange for the right to collect $1,000 30 days later, while you collected $990 immediately.

In this transaction, you ended up losing $10 bucks on the deal, but you transferred the uncertainty of potentially not being able to collect $1,000 from Customer A to Company B. Just because a customer promised to pay you $1,000 30 days later doesn’t mean you will collect on it. Many customers default on their payments.

When factoring, you determine how much cash today is worth to you. In this example, it cost you $10 or 1% of the $1,000 accounts receivable to get the cash today. In larger companies, this practice is also commonly referred to as the securitization of assets. Companies sell their assets (the accounts receivables) at a discount in exchange for cash upfront.

Although it might sound a bit complex, it is really not and has become relatively fast and easy to execute. Factoring is a widely accepted and used business tool to support business strategy such as securing working capital to sustain the business or growth capital to expand it.

Because you are accelerating your cash flow and mitigating the risk of not collecting from your customers, you are in a position to recycle the cash into profitable initiatives sooner than otherwise. Smaller business owners also refer to this method of expediting cash flow as invoice factoring.

With all that said, there is an important distinction I’d like to highlight between accounts receivable financing and a business loan. In a loan, you are taking on debt on your balance sheet, on which you pay interest to service the debt over time. When factoring, you are not taking on debt. You are trading one asset (accounts receivables) for another (cash).

In fact, when I was struggling to raise growth capital through debt funding, no bank was willing to lend to me. In fact, even the Small Business Administration (SBA) denied my application for a loan despite a solid 18 month track record.

It was then when I resorted to factoring, and have done it ever since. It’s a great solution not only to cash flow issues, but also a risk mitigation mechanism and growth strategy.

There are some accounts receivable financing companies out there that allow you to open up an account online, and get you the cash you need within 48 hours of opening. That is just 2 days! And once you have the ball rolling, the ongoing process takes less than 24 hours or one day.

Choosing the right accounts receivable financing company can take some time, but if you are fortunate to partner with the right one, this relationship can propel your business to newer heights.