What is Accounts Receivable Financing?
Accounts receivable financing, also called factoring, is a method of selling receivables in order to obtain cash for company operations. Accounts receivable (A/R) are amounts owed by customers for goods and services a company has sold to those customers.
How Does Accounts Receivable Financing Work?
Let's say Company XYZ sells widgets. It has about $1 million in receivables from customers who have not paid for their widgets.
Company XYZ needs cash right away because it is trying to finish building a factory. A/R is an asset, and as such, it appears on the balance sheet. In particular, A/R is a current asset, meaning that the amount owed is expected to be received within the next 12 months.
Company XYZ calls a factor, which purchases the receivables for $750,000. In the deal, Company XYZ gets $750,000 right away, and the factor gets the right to all the money from the receivables ($1 million). A factor is a financial institution that purchases receivables from a company. The factor then assumes the risk of customers paying late or not paying at all.
Why Does Accounts Receivable Financing Matter?
Accounts receivable financing can be a complicated process, but the basic idea is that companies can trade cash flows later for cash flows now, which is very useful for companies that need cash right away. It can also be expensive, as the example shows (Company XYZ gave up $250,000 of its receivables for the deal).
Because factors assume the risk of collecting the receivables, they are very choosy about which companies they work with and the creditworthiness of the companies' customers.