Building Your Business Operations & Success Accounting The Pros and Cons of Accounts Receivable Financing By Marco Carbajo Marco Carbajo Twitter Marco Carbajo is a credit specialist and owner of Business Credit Insiders Circle. His expertise includes guiding businesses and start-ups in securing funding without putting personal assets at risk. He previously worked as a credit analyst for Credit Education Services. learn about our editorial policies Updated on September 19, 2022 Fact checked by J.R. Duren In This Article View All In This Article Pros and Cons of Accounts Receivable Financing How AR Financing Works Dating the Invoice Length of the Agreement Full Recourse, Reserve Accounts, and Reserve Amounts Frequently Asked Questions (FAQs) Photo: svetikd / Getty Images Commonly known as factoring, accounts receivable (AR) financing is a common type of commercial financing. In simple terms, it is a process that entails the selling of receivables or outstanding invoices at a markdown to a specialized factoring or finance company—normally called "the factor". The factoring company assumes the risks on the receivable and in return issue your business with a swift influx of cash. The amount value issued on the receivable largely depends on the "age" and quality of the receivable. The benefits of accounts receivable financing for businesses can be hard to resist. The system offers the lure of getting immediate financing to enhance business growth. Key Takeaways Accounts receivable financing, also known as "factoring," is a way for small businesses to get fast funding via cash advances for unpaid invoices. AR financing is fast, doesn't require collateral, and allows you to maintain control of your business.However, AR financing comes with high costs, lengthy contracts (in some cases), and there's the possibility you're on the hook if your debtor doesn't pay your factor company. Pros and Cons of Accounts Receivable Financing Pros No need for collateral Retain ownership of your business Fast financing Cons Higher costs Lengthy contracts Debtor may not pay Pros Explained No need for collateral: It is a type of unsecured business financing option that does not require any collateral in the form of assets and guarantors.Retain ownership of your business: This type of financing does not require you to give out part of your business ownership to acquire finances.Fast financing: Factoring companies can typically advance an invoice within 24 hours of submitting. Cons Explained Higher costs: While it is a quick way of accessing cash for your business, it may come at higher costs than the rates charged on other types of business loans. Remember that failure to pay back the amount within the predetermined period will only increase the total amount that you will be required to pay.Lengthy contracts: Some agreements can be short and viable, but others can be more long and winding than you would like. It is crucial, however, to negotiate the length of the contract that perfectly works for you and your business.Debtor may not pay: The person or company who owes you money may not pay the factoring company, which may mean you're on the hook for what they should've paid. How AR Financing Works AR financing can take various forms. The business owner using this method must understand if their agreement is structured as a loan or as a sell of assets. Accounts receivable are unpaid and outstanding bills that are due to a business. On a balance sheet, these items fall into the category of a current asset and are seen as one of a company's liquid assets. Liquid assets are those possessions that can be turned into cash easily, Asset Sell Most of this type of financing takes the form of a selling company assets. Here, the due accounts are sold to another company in return for cash. The lender will usually pay only a portion of the total AR value to the business. Once sold, the lender assumes the responsibility of collecting the debt. Loan and Collateral When your AR financing is structured as a loan, the AR book is seen as collateral to the loan. The company retains the ownership of the AR book and the duty to collect on those debts. Business owners should ensure that the deal has a prime rate, which in essence is the varied interest amount. They should find out how the prime rate is calculated and whether it is tied to the factoring. Keep in mind that a prime rate is an essential part of accounts receivable financing. Note Any form of business, whether small or big, will at one point require business credit to support various day-to-day operations of the business. At one point, the business may require quick money to fix its operations. Accounts receivable financing can help businesses overcome those financial challenges. Dating the Invoice The purchase date is another element of the agreement that you must put into perspective. In normal cases, invoices are payable within more than 90 days. Factoring companies may prefer invoices that are newer and have a longer collection shelf-life than those that are near-term or delinquent. Length of the Agreement The length of the AR financing agreement is important for the business to consider. Whether the AR agreement goes for months, a year or several years can have varying impacts on a company. Be sure that you are well aware of the length of the agreement, and whether a short-term or long-term agreement will be vital for your business. Full Recourse, Reserve Accounts, and Reserve Amounts Some AR financing may include a full recourse clause. Under this provision, the lender can force the business to pay any invoices that are uncollectable after a specified period. Some agreements allow the factoring companies to take a percentage of the paid invoices and place those funds into a reserve account. The reserve account will help to cover any uncollectable invoices. Finally, contracts may contain a reserve amount condition. This clause allows the factoring company to withhold some of the finance funds until invoices are paid. Frequently Asked Questions (FAQs) What is accounts receivable financing? AR financing, or "factoring," is a way to get funding via unpaid invoices. Typically, you sell the invoice to a factor (the company that funds you), which then advances you part of the invoice and pays out the rest (minus fees) when the invoice is paid. What are the drawbacks of accounts receivable financing? Typically, AR financing comes with high fees, some of the contracts can be lengthy, and, in some cases, you'll be on the hook for the invoice balance if your debtor doesn't pay in full or at all. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Boston University. "Technology Development: Many Types of Financing Assisting So Many Paths to Market," Slide 37. Boston University. "Technology Development: Many Types of Financing Assisting So Many Paths to Market," Slide 46. FreshBooks. "7 Questions About How Accounts Receivable Financing Works." altLINE. "What Is Accounts Receivable Financing?"