What Is Accounts Receivable Finance & How It Works

Accounts receivable finance allows businesses to transform their outstanding customer invoices into immediate cash. This process provides companies with liquidity, enabling them to meet operational needs and pursue growth opportunities without waiting for traditional payment terms. It represents a strategic method for businesses to manage their cash flow effectively by leveraging a significant asset on their balance sheet. This financial strategy is particularly relevant for businesses that extend credit to their customers.

What is Accounts Receivable?

Accounts receivable (AR) refers to the money owed to a business by its customers for goods or services that have been delivered but not yet paid for. These are claims for payment held by a business, typically arising from sales made on credit terms. Accounts receivable is recorded as a current asset on a company’s balance sheet, representing the total value of outstanding invoices. This balance signifies future cash inflows, as payment terms often range from 30 to 90 days after the invoice date, creating a time lag between delivery and cash receipt.

The creation of accounts receivable is fundamental to many business transactions, especially in business-to-business (B2B) environments where extending credit is common. When a business provides goods or services, an invoice is issued, formally documenting the amount due and the payment terms. This practice allows customers to receive products or services immediately while deferring payment, which can facilitate larger transactions and build customer relationships. While AR represents an asset, it is not liquid cash until collected, requiring careful management for operational stability and growth.

How Accounts Receivable Finance Works

Accounts receivable finance operates on the principle of a business obtaining immediate capital by leveraging its outstanding customer invoices. This financial mechanism involves a third-party financial institution, such as a factoring company or a lender, providing funds in exchange for the value held within these receivables. A business needing quick working capital identifies its unpaid invoices from credit sales and approaches a financier with its eligible invoices.

Before advancing funds, the financier conducts due diligence, assessing factors like the credit quality of the business’s customers and the receivables aging report to determine the risk involved. Upon approval, the financier advances a percentage of the invoice’s face value to the business, often ranging from 70% to 90%. This upfront payment provides the business with immediate liquidity, allowing it to cover operational expenses, invest in new projects, or manage cash flow gaps.

The remaining percentage of the invoice value is held in reserve by the financier until the full amount is collected. The goal of accounts receivable finance is to accelerate cash flow, transforming future payments into present working capital. The specific arrangement dictates whether the financier or the business manages collection. Once the customer settles the invoice, the financier releases the held reserve, deducting any agreed-upon fees. This approach helps businesses unlock capital tied up in their sales cycle.

Common Types of AR Finance

There are two primary forms of accounts receivable finance, each with distinct structural and operational differences.

Factoring

Factoring involves the sale of accounts receivable to a third-party financial institution, known as a factor. The business sells its invoices at a discount in exchange for immediate cash. The process begins with the business submitting its unpaid invoices to the factor for verification. The factor then advances a percentage of the invoice’s value, commonly ranging from 70% to 90%, to the business. The factor assumes responsibility for collecting the full invoice amount directly from the customer.

Factoring agreements differ in how risk is allocated for customer non-payment. These are categorized as recourse or non-recourse factoring.

In recourse factoring, the original business retains the credit risk; if the customer fails to pay, the business is responsible for the loss. This type of factoring is less expensive due to the lower risk assumed by the factor.

Non-recourse factoring means the factor assumes the credit risk for approved invoices; if the customer defaults, the factor absorbs the loss. Non-recourse factoring typically comes with higher fees because the factor takes on greater risk. The factor manages the collection efforts.

Accounts Receivable Asset-Based Lending (ABL)

Accounts Receivable Asset-Based Lending (ABL) is where a business obtains a loan or a line of credit secured by its assets, with accounts receivable serving as the primary collateral. Unlike factoring, the business retains ownership of its invoices and remains responsible for collecting payments from its customers. The ABL lender evaluates the quality and value of the business’s eligible accounts receivable to establish a “borrowing base.” This borrowing base determines the maximum amount the lender is willing to advance, typically as a percentage of the eligible AR.

Funds are advanced as a percentage of this eligible accounts receivable, with common advance rates ranging from 70% to 85%. The business draws on this loan or line of credit as needed for working capital or other business expenses. As customers pay their invoices, the business repays the loan, and the available credit line may replenish, allowing for continuous access to funds. The lender monitors the borrowing base through reports to ensure the collateral value supports the outstanding loan amount. This method provides flexibility, allowing businesses to leverage their receivables without selling them outright or transferring their customer relationships.