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Account Receivable Loans: Everything You Need To Know

Welcome to our in-depth guide on account receivable loans. In this extensive post, we will define what an account receivable loan is, discuss how it works, explore the typical costs and terms, examine who they may benefit, address common risks and challenges, and answer frequent questions from business owners. By the end, you’ll have a comprehensive understanding of this financing option to make an informed decision about whether it could work for your company. Let’s get started!

What is an Account Receivable Loan?

An account receivable loan (also called an AR loan or factoring) is a type of short-term financing where a business uses its outstanding invoices (accounts receivable) as collateral for a loan. With an AR loan, a lender will advance a business cash upfront based on the unpaid invoices the business has already sent to its customers. Then, when those customers pay their invoices later, the repayment goes directly to paying off the loan.

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Essentially, an AR loan allows a business to convert its uncollected accounts receivable into immediate cash. Rather than waiting 30, 60, or 90 days for customers to pay invoices, the business gets 50-90% of the invoice amount paid upfront. This provides working capital for expenses like payroll, inventory, or other operational needs.

Some key things to know about AR loans:

  • Collateral is unpaid customer invoices, not business assets. This makes AR loans easier to qualify for than traditional bank loans.
  • Lenders evaluate the creditworthiness and payment history of the business’s customers, not just the business itself.
  • Repayment is made automatically as customers pay down the outstanding invoices. The lender collects the full amount due from customers.
  • Interest rates are typically greater than conventional business loans, but funding can be provided much quicker.

By understanding this introductory overview, we can now explore AR loans in more depth. Let’s unpack the typical process, costs, terms, and who might benefit from this financing option.

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How an Account Receivable Loan Works

Here are the standard steps involved in obtaining and utilizing an AR loan:

1. Application and Underwriting

The business applies for a loan with a factoring company or specialty lender. As part of underwriting, the lender will request documentation like financial statements, accounts receivable aging reports, customer invoices, tax returns, and details on existing customer payment histories.

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2. Loan Approval and Funding

If approved, the lender will decide how much of the outstanding receivables they are willing to advance. This is usually between 50-90% of the total invoice amounts, depending on factors like customer creditworthiness, payment terms, and industry.

3. Assignment of Accounts Receivable

The business legally assigns the approved customer invoices over to the lender as collateral. The lender is now entitled to collect payment on those invoices directly from the customers.

4. Receiving the Cash Advance

Once the assignment is complete, the business receives the agreed-upon percentage as an upfront cash payment, usually deposited within 1-3 business days.

5. Customer Payments Go to Lender

Subsequent customer payments on the assigned invoices now go directly to the lender rather than the business. The lender applies these funds to repayment of the AR loan plus interest and fees.

6. Loan Is Paid Off

Once all assigned invoices are paid in full by customers, the loan is considered repaid. Any surplus funds beyond repayment are returned to the business.

This basic process allows a business to immediately access non-yet-collected cash from its receivables rolling in over the following weeks or months. Let’s explore the typical costs and structures of AR loans.

Costs and Terms of Account Receivable Loans

While interest rates and structure can vary between lenders, here are some common benchmarks for AR loan terms and pricing:

Advance Percentage

As mentioned, most lenders will advance between 50-90% of total approved receivables, with the average being around 80%. This percentage is decided based on credit risk factors.

Interest Rates

Interest rates on AR loans tend to be higher than traditional bank loans since the business’ customers serve as collateral rather than assets. Rates often range anywhere from 4-10% per 30 days, depending on loan volume, customer quality, and repayment terms.

Origination/Broker Fees

Upfront fees of 1-5% of the total loan amount are common to cover underwriting, documentation, and funding expenses. Some lenders roll these fees into the total interest charged, while others collect them upfront.

Repayment Terms

Most AR loans have repayment schedules matching the assigned invoice due dates, usually 30-120 days. Balances are typically due in full once all receivables are collected, often with a final interest charge. There is no penalty for early repayment.

Renewal Options

Many borrowers take out repeat AR loans as new invoices are generated. Lenders may renew loans at the borrower’s request for an additional fee of 1-2% as long as the receivables quality remains sufficient.

Personal Guarantees

For smaller businesses, lenders sometimes require business owners to personally guarantee AR loans in case of default. This can put personal assets at risk.

Overall, AR loans provide rapid funding but carry bigger interest rates than bank loans due to the risk profile. The exact structure depends on negotiation between lender and borrower based on loan size, volume, and receivables quality factors.

With an understanding of costs and mechanics now in place, let’s assess what types of businesses may find AR loans most suitable to their needs.

When Are AR Loans a Good Option?

Account receivable financing tends to be practical for businesses that meet the following criteria:

  • Have an established customer base with a history of on-time invoice payments
  • Generate regular, predictable cash flows from invoices to quality customers
  • Need faster access to cash flow than waiting 30-90 days for receivables collections
  • Require funding for operational, materials, payroll, or growth capital needs
  • May have exhausted traditional bank financing or credit options
  • Don’t want to relinquish business ownership through other types of financing
  • Can tolerate higher interest rates relative to assets-based commercial loans

Some specific industry examples where AR loans are commonly used include:

  • Manufacturing – For inventory, production, and supply chain financing needs
  • Professional services – For cash flow timing gaps between project billings and payments
  • Healthcare/Medical practices – To cover payroll, materials, and equipment costs between service periods
  • Construction – For upfront project costs prior to receiving progress/completion payments
  • Staffing/Recruiting firms – To fund placement bonuses payroll between invoicing cycles
  • Technology/Software firms – To smooth invoices/renewals cash conversion cycles

In summary, AR loans are suited to businesses that generate reliable, quality receivables but experience timing gaps between invoice issuance and collection that require working capital support. The higher rates are offset by faster funding access compared to traditional bank loans.

Of course, there are also some instances where AR loans may not be the optimal solution. Let’s cover some potential downsides or risks to consider.

Risks and Drawbacks of AR Loans

While AR loans provide cash flow benefits, there are also risks businesses must carefully evaluate:

  • Higher interest rates – Rates can be 2-5x higher than traditional bank financing, significantly increasing total financing costs over time.
  • Full repayment required – The loan must be paid off in full once all assigned receivables are collected from customers. Extension options may carry additional fees.
  • No revenue/receivables growth flexibility – Once loans are taken out, a company loses flexibility if revenues or receivables grow faster than expected. Additional financing may be needed.
  • Customer payment responsibility transfers – Businesses lose control over directly collecting from customers on assigned invoices. This introduces new parties to billing/collection processes.
  • Customer credit risks are inherited – If any assigned customers default or pay invoices late, it impacts the business’s ability to repay the AR loan as agreed.
  • Personal guarantees may be required – Owners can be personally endangered if the business is unable to repay an AR loan from receivables collections.
  • Less funding than requested may be approved – Lenders determine advance percentages based on perceived credit/industry risks, which can leave a gap versus capital needs.

To mitigate risks, businesses must carefully consider customer creditworthiness, underwrite costs versus benefits accurately, and have contingency plans for revenue variances or late payments outside their control. AR loans aren’t a magic bullet, and diligence is necessary upfront.

We’ve now covered AR loans comprehensively, from concept to mechanics to suitability. To conclude, let’s address some frequently asked questions business owners may have:

FAQ on Account Receivable Loans

1. How quickly can I receive funding after applying for an AR loan?

Once a completed application is submitted, funding from AR loan lenders is generally much quicker than traditional bank loans. Processing times can range from 1-10 business days on average, depending on the lender’s review process and availability of required documentation. Some specialty lenders advertise funding within 24-48 hours for pre-qualified applicants.

2. What documentation will a lender require from me?

Common application requirements include two years of company tax returns, current profit and loss statements, accounts receivable aging reports, customer invoices to be assigned, detailed personal and business credit reports, and authorization to pull credit for business owners. The lender will need this material to thoroughly underwrite the customer base and financial strength of the borrowing company.

3. Are there any restrictions on how I can use the funds?

Most lenders will allow AR loan funds to be used flexibly for general working capital needs like payroll, inventory, materials, and other operational expenses. However, the money cannot be used for things like owner draws, dividends, speculative investments, or paying off unrelated debt. It must go towards supporting the ongoing business that generates the receivables serving as collateral.

4. How long do I have to repay the loan?

Standard AR loan terms match the assigned invoice repayment periods, usually 30-120 days. Some lenders also offer single-payment loans due on a fixed future date. However, most businesses end up renewing AR loans in cycles as new receivables are generated rather than fully repaid. Early repayment without prepayment penalties is usually allowed if cash flows permit.

5. What happens if a customer pays late or doesn’t pay at all?

If an assigned customer pays late, the business will be responsible for any additional interest charged by the lender during the delay. For uncollectable receivables where customers ultimately do not pay, the business becomes liable to cover the outstanding amounts owed to the lender. This risk is why AR lenders carefully evaluate customer creditworthiness upfront.

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