What is Accounts Receivable Discounting
Accounts receivable discounting is the process of obtaining a loan against the value of a company’s receivables. It is also known as accounts receivable factoring. The receivables themselves are recorded as an asset but the loan against those receivables is recorded as a liability because it must be repaid to the lender.
Benefits of Accounts Receivable Discounting
When companies sell products or services to their customers, they often grant payment terms that allow their customers to pay within 30 to 90 days. While the supplier is waiting to collect payment from their customers, they can experience cash flow problems relating to the cost of delivering the goods and services and meeting their overhead requirements.
Accounts receivable discounting allow them to borrow against the expected value of their receivables (the unpaid invoices for the goods and services) and use that money to pay their expenses.
Differences between accounts receivable discounting and accounts receivable factoring
Accounts receivable financing (or AR financing) can take two different forms: discounting (a loan) or factoring (an asset sale).
In a loan arrangement, known as accounts receivable discounting, a financial institution will make a loan to a business that is backed by the business's accounts receivable assets. Those assets are put up as collateral on the loan and if the business fails to repay the loan, they will be turned over to the lender.
Accounts receivable assets are not the same as cash, of course. If the lender did foreclose on the company's accounts receivable they would still need to go through the process of collecting the owed money that the accounts receivable represent.
In accounts receivable factoring, a factoring platform or other financing company will buy another company's accounts receivable assets outright, generally for around 90% of the price. The factoring platform hopes to collect the accounts receivable in a timely manner and make money on the difference between the purchase price and the total value of the accounts receivable collected.
Businesses need enough readily available cash or working capital to pay their employees, expenses, debt obligations and any investments they make in customer orders. If a company makes an unusually large amount of sales in one month that can present a working capital problem. They will need to invest large sums of money to complete and deliver customer orders, but may not be paid for those orders for 30, 60 or 90 days.
Accounts receivable discounting can be a good way for a company to acquire the working capital it needs to maintain operations and grow their sales.
How To Structure Accounts Receivable Discounting
Almost every type of receivable from a reputable and creditworthy company is eligible for discounting. But there are some noteworthy exceptions:
- Receivables that are majorly past due are not eligible for discounting.
- Receivables that are under dispute from a customer are not eligible for discounting.
- Receivables from a customer that is bankrupt or in the process of declaring insolvency are not eligible for discounting.
- Receivables that have been billed but are associated with goods or services that have not been delivered are not eligible for discounting.
- Receivables that are due from consumers are not eligible for discounting.
- Receivables from a customer that is past due on other invoices are not eligible for discounting.
These types of receivables represent too great a risk to financiers to make loans against. Accounts receivable financing companies are looking for reliable sources of future revenue to finance against.
Accounts receivable loans work like most loans, but they use a businesses unpaid invoices as collateral. The financing company will lend the borrowing company a lump sum of money - giving them instant cash. The borrower may be charged a fee between 1 and 5 percent of the total loan amount dependent on their size and creditworthiness.
As the collateralized invoices are paid, the borrowing company sends the money to the financing company. After all collateralized invoices have been paid, the financing company pays the balance of money above the loan amount and minus the fee back to the borrower.
Who Uses Accounts Receivable Discounting
Accounts receivable discounting can be used by any business big or small that wants to trade their accounts receivable assets for cash.
Accounts receivable lending represent a risk as assets, because there is a chance that they will not be collected. Converting accounts receivable to cash via a loan or asset sale is a way to mitigate the risk of non-collection.
It’s also a tool that can be used by companies who need cash quickly. Accounts receivable discounting can get them cash immediately, though almost always less money than the total value of the accounts receivable assets.