03 Jan Financing working capital with accounts receivables: part one
Financing working capital can be done in many ways, ranging from equity and credit lines to short-term loans and using accounts receivables. Common forms of this latter financing means will be explained and discussed in this two-part series on how to generate working capital. In this first part, we will give an introduction to accounts receivable financing and explain traditional and reverse factoring. In the second part, we will discuss asset-based lending and selective accounts receivable financing.
Accounts Receivable Financing: An introduction
Accounts receivable financing involves companies using a portion of or all of their outstanding invoices as collateral, for a fee, in exchange for advanced funds. These funds are advanced to companies against the value of a portion of their invoices, and can be done in a few main ways: traditional factoring; reverse factoring; asset-based lending; and selective accounts receivables financing. Much of this can also be carried out online or with the use of specialised software, which makes financing working capital easier.
In traditional factoring, a factoring company provides financing for some or all of an entity’s unpaid accounts receivables. This can be done quickly, and is hence a boon for companies seeking to access working capital quickly when compared to traditional business loans. Although it must be noted that factoring companies often take a greater percentage than banks, there can be hidden fees, such as processing, application, credit or late fees if a client fails to meet a payment deadline, and factored receivables are noted on balance sheets as debt.
With factoring, receivables are sold to the factoring entity for a discounted rate in exchange for advanced payment, and are not used as secured assets to finance working capital. Here, payment in made in two parts, the first being a percentage of the whole, usually between 70-90% of the total sum, when the unpaid invoices for financing are given to the factoring entity. The remainder of the sum is given once the factoring party has collected the entire unpaid amount and taken their fee, called a discount rate, which usually runs between 1-5%. Because invoices are sold to factoring entities, companies do not have to worry about collection, which frees up time to focus on their principle business activities. Companies that choose factoring as an option often factor their invoices weekly, and if not weekly, on a regular basis.
In terms of determining the value of the unpaid invoices, factoring companies evaluate who owes the debt and how new the invoices are. The larger the company, the more value the invoices are given, and newer invoices are given more value than older invoices. Hence, if the parties are large companies and the invoices are recent, then the factoring company is more likely to finance a larger percentage of the total owed amount upfront.
Also, factoring is a beneficial to small companies because there are low minimums for financing, unlike asset-based finance which can have high minimums. Moreover, since unpaid invoices are sold, companies with poor credit and/or a lack of collateral, or new companies, have a means of generating working capital quickly because lending entities are more concerned with the value of the invoices and whether or not debtors will pay them.
This is also known as supply chain financing because here a buyer initiates the financing on behalf of one of its suppliers with a factor, which can be a bank, a specialised company, or a finance company, who handles the early payment terms for said buyer. Here, certain invoices from suppliers to buyers are paid earlier so they can complete their part in the supply chain without the buyer incurring added expenses. The suppliers also take a discounted payment rate due to the factor’s fees for this expedited payment, yet despite this cut, it still delivers quick access to working capital. Moreover, because the buyer begins the process, their liability is engaged which gives the supplier more working capital than if they had requested the factoring service on their own because the interest rates charged are tied to the buyer and are thus lower.
How this process works is through collaboration between the buyer, supplier, and factor. The larger entity that is buying from a supplier selects receivables from the supplier that can be paid earlier by the factor. The factor then approaches the supplier with the selected invoices and the supplier chooses which ones they would like to be paid in advance.
For the initiating company, reverse factoring can be a benefit because it tightens the relationship between itself and its most important buyers. Moreover, it can finance the entirety of an invoice because the reductions are taken out on the supplier end as the price for early payment and they don’t, similarly to traditional factoring, have to devote time to filling suppliers’ requests for early payment.
Despite the above advantages, lending institutions require a large volume of invoices to be factored, meaning that this approach is not usually suitable for smaller companies. However, there are companies, like Netherlands-based Confluence Factoring, that do offer reverse factoring for SMEs.
In the next part of the series, we will discuss asset-based lending and selective accounts receivable financing. You can find this part of the series here.