Having cash flow problems is a common challenge for small and growing companies. These problems can often be solved by improving operations while using the right financing solution.
One way to improve your cash flow is to get financing secured by your accounts receivable (A/R). Your A/R can be used as collateral for a number of solutions such as accounts receivable factoring, commercial lines of credit, and asset based loans.
Lines of credit are best suited for more mature companies, while factoring and asset based loans can be used by small and midsize companies. From this article, you will learn how:
- Lenders view your A/R as collateral
- Accounts receivable financing works
- A line of credit operates
- An asset based loan works
Using your receivables as collateral
Your accounts receivable, basically invoices that will be paid in 30 to 60 days, are seen by lenders as assets that can be used to secure financing. Lenders consider A/R a strong form of collateral because it is very liquid – it turns into cash quickly.
To use your receivables as collateral, they must be high quality. In other words, your company must have good invoicing and collections practices. And your customers must have good commercial credit.
There are two ways to use your invoices as collateral. One way is to sell them outright to the finance company. Basically, you sell the financial rights to your invoices in exchange for immediate funds. The other way is to margin them, where the finance company lends against the asset. The following three funding options use one of those two methods of securing invoices as collateral.
Option #1: Accounts receivable factoring
Factoring your invoices is a tool that allows you to get financing that is secured by accounts receivable. Although the line behaves like a revolving line of credit, it’s technically a receivables sale. Your company gets financing by selling its accounts receivable to a factoring company in exchange for an immediate payment.
The sale occurs in two installment payments. The first installment covers 80% of the value of the A/R and is deposited to your bank account when you present the invoices for financing. The remaining 20%, less the finance fee, is deposited once your customers pay their invoices in full.
Companies that use factoring often finance their invoices regularly (usually weekly). This approach provides them with dependable cash flow that can be used to fund operations and growth. Since the line is tied to your accounts receivable, it can grow as your sales increase.
One advantage of factoring is that your company size does not matter. This solution is available to companies of any size, as long as they have invoices from reputable commercial clients. Get more information about A/R factoring.
Option #2: Commercial line of credit
Another solution that allows you to finance your accounts receivable is a line of credit. A line of credit provides you with funding up to a preset amount. Your company can draw funds, when needed, up to the limit. You can pay down the line as your cash flow improves.
Although some lines of credit can be secured solely by accounts receivable, they often need additional collateral because the value of the A/R changes regularly and could fall below the credit limit. Banks and lenders want to prevent this drop in value because it would leave them under-collateralized. Some lines of credit may require that you post additional collateral such as inventory, machinery, bank accounts, and other assets.
Although commercial lines of credit are very flexible and easy to use, it’s hard to qualify for them. Aside from collateral, the company must have a track record of profitable operations, audited financials, and good management controls. Business owners should consider working with an SBA lender – a strategy that can help small companies.
Option #3: Asset based loan
A third way to use your invoices as collateral for a line of credit is to get an asset based loan. As its name implies, this solution allows you to finance your company assets. Your company can finance its accounts receivable, along with other other assets such as inventory and machinery.
An asset based loan can behave like a line of credit if you use accounts receivable and inventory as collateral. Basically, you can draw from the line as invoices and inventory become available. As with a factoring line, you can only borrow up to 80% of the value of your accounts receivable. You pay off the line as cash becomes available.
As a solution, asset based loans fit between factoring and lines of credit. They are often used by companies that have outgrown their factoring facilities but can’t qualify for a line of credit just yet. Most asset based loans are offered to companies that have minimum monthly sales of $1,000,000. Learn more about asset based financing.
Which option is best for my company?
Determining which option will work best for your company is key. Using the right financing is critical to the success of the company. The product best suited for your company depends on:
- How long you have been in business
- The quality of your financial statements
- Whether your company is growing quickly or has matured
If your company is growing quickly, your best option is to use factoring or an asset based loan. These options can easily adapt to growth.
If you have been in business for less than two years and are generating less than $1,000,000 per month, factoring is the most realistic choice. On the other hand, if your company is generating more than $1,000,000 per month in sales and has reasonable financial statements, consider an asset based loan.
Lastly, if your company is more established, has good financials, and is only experiencing slow to moderate growth, a line of credit may be the best option.
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Note: This article is for information purposes only and does not intend to provide financial advice. If you need financial advice, please consult a specialist.