What is accounts receivable (AR) financing?

Accounts receivable or AR financing is a type of financing arrangement which is based on a company receiving financing capital in return for a chosen portion of its accounts receivable. An AR financing arrangement can be structured in several ways, including as an asset sale or a loan.

Essentially, you can think of it as a line of credit that’s backed by outstanding debt due to be received from customers or clients. AR financing allows for the deployment of capital that would otherwise be unusable until the debtor settles their invoice, providing more working capital to utilise in the short-term.

The amount of working capital that can be unlocked through AR financing is based on what’s tied up in a business’ accounts receivable – the balance of outstanding money due to them for goods or services delivered or used but not yet paid for by customers. Accounts receivable are listed on the balance sheet as an asset, as it’s essentially money that is owed to the company.

Accounts receivable exists because most companies operate by allowing a portion of their sales to be on credit. For some, this credit will be extended to frequent customers that receive periodic invoices, enabling them to avoid making manual payments for each transaction.

In other cases, a business might provide all of their clients the ability to pay after receiving the service. The extent to which a business allows for payment on credit determines the potential size of their accounts receivable, and therefore the funding that’s available to them through AR financing.

AR finance example

The following hypothetical example of an accounts receivable financing arrangement will help you understand how the financing method works:

A clothing retailer orders $50,000 worth of product from a manufacturer, as part of a contract with 90-day payment terms. Once the purchase order has been received by the manufacturer, the $50,000 becomes part of their accounts receivable. It will remain classified as AR until the payment is made in full by the retailer.

The manufacturer, keen to increase their working capital, contacts a financer and transfers the outstanding invoice, worth $50,000, in exchange for a 90% cash advance. This means they receive $45,000 immediately, which they can use to fuel growth or build resilience.

The financer takes responsibility for collecting the invoice, and receives the full $50,000 in payment from the retailer on or before the invoice due date. Depending on the terms of the AR financing arrangement, they’ll then send the remainder of the invoice amount ($5,000) to the manufacturer, minus a fee for their service.

Benefits of accounts receivable finance

Financing accounts receivable is a fundamental part of many companies’ working capital management strategy. These are the key benefits for businesses that employ AR finance:

Quicker cash flow

The main and most obvious benefit of AR financing is that it facilitates fast cash flow. Instead of having to wait for invoices to be paid for working capital to be freed up – with AR finance you can make full use of all of your assets (current and owed) whenever you want. This can be a game-changer for high-growth businesses with short cash runways, helping them to make the best use of their assets.

Fewer distractions

Outside of actually quickening cash flow, AR finance also takes the pressure off needing to chase invoices for prompt payment. Since you can borrow money that would otherwise be tied up in unpaid invoices with an AR finance agreement, it’s less urgent for you to aggressively pursue debtors. That means you can focus more on maximising the use of your working capital.

Cheaper than alternatives

AR finance is generally user-friendly compared to alternative working capital management methods. Most importantly, it tends to be quicker, cheaper, and less limiting than a bank loan. It’s also highly flexible, allowing businesses to decide what portion of their accounts receivable to raise capital against, depending on their needs at the time.

Why are accounts receivable considered current assets?

A company has receivables if it has made a sale on credit but has yet to collect the purchaser’s money – it’s essentially a short-term IOU agreement.

Businesses record AR as assets on their balance sheets because the customer is legally obliged to pay the debt. Further, as accounts receivable are current assets, they are due from the debtor in one year or less.

Accounts receivables vs accounts payable

When a company owes debts to its suppliers or other parties, these are accounts payable. Accounts payable is the opposite of accounts receivable – any business-to-business credit agreement creates AP and AR. To illustrate this, consider the following example:

Company A cleans Company B’s window and bills them for the service.

Company B now owes them money, so it records the invoice value in its accounts payable.

Company A is waiting to receive the money, so it records the invoice value in its accounts receivable.

AR finance as part of a wider working capital strategy

An accounts receivable financing solution is just another string in your working capital bow, and often works best as part of a wider working capital management strategy alongside dynamic discounting and other supply chain finance solutions. How you utilise your accounts receivable depends on the objectives of your business.