Late client invoice payments, lengthy payment schedules and seasonal demands can lead to cash flow shortages during the year. Accounts receivable financing helps small businesses cover temporary shortfalls and meet expenditure requirements in key periods, providing fast access to capital from money due without incurring ongoing debt.

We explore this handy financing method, including how it works, the different accounts receivable finance options, pros and cons to consider and alternatives, such as business loans, lines of credit and merchant cash advances.

What is accounts receivable financing?

Accounts receivable financing (AR financing) turns your unpaid invoices into instant cash flow. The amount you can borrow through accounts receivable financing is based on the value of your outstanding invoices, typically providing a percentage of their value minus fees.

The principle is simple: you've done the work, sent the bill, but your customer hasn't paid you yet. Instead of waiting, a lender gives you a portion of the invoice amount upfront, typically 80-95%. They then collect the full payment from your customer, keeping a fee for their services.

Financing accounts receivable is a way to leverage your existing assets (unpaid invoices) to get the funding you need right now. This makes it a great solution for businesses with long payment cycles or those who need a quick cash injection to cover expenses, invest in growth or handle unexpected challenges.

Accounts receivable financing vs factoring 

There are several types of accounts receivable financing, each with slightly different methods and structures, depending on the level of financing required and the degree of control and discretion you prefer. Invoice factoring, for example, is just one form of getting your receivables paid in advance by a third party, with the factoring company taking responsibility for chasing and collecting the eventual payments from your clients. 

How does accounts receivable financing work?

Accounts receivable finance is a short-term business financing option, so the process is relatively quick and straightforward, apart from larger and more complex financing requirements.

Here are the typical steps involved in financing accounts receivable:

1. Invoice submission: You send your outstanding invoices to a financing company. They'll review them to assess the creditworthiness of your customers and the overall risk.
2. Approval and advance: Once approved, you'll receive the vast majority of the invoices’ value upfront (an agreed percentage). Funds should arrive quickly, often within 24-48 hours.
3. Customer payment: Once your customers pay their invoices, the financing company will receive the total amount.
4. Remaining balance and fees: From the invoice payments received, the accounts receivable finance provider will transfer the remaining percentage owed to you, minus their fees.
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What are the typical accounts receivable financing fees and rates?

As accounts receivable financing isn't technically a loan, it doesn't have interest rates. Instead, providers charge a factor or discount fee, usually quoted as a percentage of the invoice value, which accounts for time taken to receive the customers’ payments – kind of like interest on money owed – risk and administrative costs, such as chasing/collection (if your agreement involves the provider taking ownership of this).

Fees will vary, depending on the following factors:

• The value of your invoices.
• The creditworthiness of your customers.
• The age of your invoices.
• The type of accounts receivable financing chosen (e.g. invoice factoring, discounting, etc.), whether it’s a recourse or non-recourse arrangement and if it’s a discreet method.
• The finance provider you choose.

However, you can expect to receive between 80% and 95% of the value of accounts receivables ‘sold’ to the provider in advance, with fees ranging from 1 to 5% of the remaining amount.

You may also need to pay an initial set-up fee, especially if using an ongoing financing facility. Set-up fees are usually between £500 and £2,500, depending on the size and complexity of the arrangement.

Accounts receivable financing use cases

Most types of accounts receivable financing are viewed as short-term solutions for easing cash flow issues and financial pressure in key periods. You have money coming, but you need it now, for various purposes.

Here are some of the typical accounts receivable financing use cases, which may strike a chord with challenges your business faces:

• Getting advanced access to incoming capital to fund project expenses, such as staffing, tools and materials in construction/property development projects.
• Plugging cash flow gaps in other sectors with lengthy payment schedules.
• Enabling retailers to boost inventory in key sales periods to avoid stockouts – another option is inventory finance, which uses existing and future inventory as security to borrow capital to invest in new stock. 
• Covering unexpected expenses, say, to repair equipment or upgrade systems.
• Easing the pressure of cash flow shortages when tax bills are due.
• Allowing businesses to take advantage of investment/growth opportunities.
• Greater scope for taking on new business while covering the costs of existing projects. 

Accounts receivable and inventory financing, plus other forms of asset-based lending, offer ways to free up working capital for numerous operational uses and minimise cash flow problems.

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Accounts receivable financing example 

As an accounts receivable financing example, let’s use the scenario of cash flow challenges in construction to show its benefits for businesses in this sector:

• A construction company secures a sizable contract but requires significant upfront expenditure for key materials, equipment and subcontractors. Due to the project’s long timeline and staggered payments for project progress and completion, cash flow is under pressure. Any current or future cash shortages risk delaying the project.
• To maintain liquidity without seeking long-term borrowing, the firm decides to use invoice factoring for an advance on pending client invoices, giving them the necessary funds to acquire key assets and move the new project forward. 
• The finance provider collects payments directly from clients, upon their due date, while the firm makes progress on the project without dipping into cash reserves, taking on debt or impacting other operations. The client is satisfied that the project is making the required progress to keep things on track.

Main types of accounts receivable financing

Accounts receivable financing, depending on your business needs, including whether you’re looking for a one-off advance or an ongoing financing facility and the level of control and discretion you’re after.

Here are the main accounts receivable finance solutions to choose from:

Invoice factoring

A form of invoice finance, invoice factoring involves finance providers ‘buying’ your chosen invoices, paying you a large percentage of the value in advance and forwarding the rest, minus their fees, once they’ve received payment from your clients. Factoring providers typically take responsibility for collecting your client’s invoice payments.

Invoice discounting

With invoice discounting, you also get an advance of a large percentage of your invoice value, but you’re responsible for chasing and collection, making it a more discrete option. Providers may quote the cost of borrowing as a “discount rate", which is just the inverse of a factor rate.

Invoice factoring solutions are often more expensive than discounting due increased management required on the provider’s side. However, discounting is tailored to established companies, and many providers have a minimum turnover threshold. 
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Forfaiting

Forfaiting is similar to invoice factoring, but is specifically for companies exporting goods. Based on large-scale transactions and long-term receivables for capital goods (non-consumer items), users can receive an advance of the money owed by the importer, rather than having to wait for a long period to receive the funds. 

As a type of trade finance, forfaiting can involve various financial instruments, such as promissory notes and letters of credit.
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Selective receivables financing 

Usually referred to as selective invoice finance or spot factoring, selecting receivables financing involves choosing certain outstanding invoices to be paid in advance, which suits smaller businesses that want flexibility over what to fund rather than committing their entire receivables ledger to the facility.
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Accounts receivable financing comparison table 

Check out our table below to compare different accounts receivable financing solutions across various suitability factors:

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Choosing between recourse and non-recourse receivables finance

Accounts receivable financing is a form of asset-based lending, where your receivables act as the assets used to secure the loan/advance, reducing lender risk. However, eligibility and terms are largely determined by your clients’ creditworthiness.

Another factor to consider is who is liable if your clients fail to pay your invoices or run into financial difficulties. That is where accounts receivable financing providers will have recourse or non-recourse options. 

Recourse receivable financing is when your business retains the credit risk, while non-recourse financing sees the finance provider assuming the risk of client non-payment, which comes with a higher cost of borrowing to account for the increased lender risk.
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Pros and cons of accounts receivable financing

As with any business finance solution, there are pros and cons to consider, from the speed and flexibility of funding to the cost of borrowing. 

Here are the main advantages of accounts receivable financing and potential drawbacks to consider before deciding whether it’s a good option for your business:

Key benefits of accounts receivable financing

• Fast access to cash: Unlike traditional loans, which can take weeks or months to process, you can access an accounts receivable financing loan (or advance) within days, to cover urgent expenses or seize growth opportunities.
• Improved cash flow management: By receiving upfront payments for outstanding invoices, you can better manage your cash flow and avoid the stress of waiting for customers to pay.
• No need for strong credit history: Since the financing is based on your customers' creditworthiness, businesses with less-than-perfect credit scores can still qualify, opening up funding opportunities that might not be available through traditional lending channels, especially for newer businesses.
• Simplified collections: If using factoring, the burden of chasing late payments shifts to the factoring company, freeing up your time and resources to focus on growing your business.
• Scalable financing: As your sales increase, so does the amount of finance you can access, making accounts receivable financing a flexible solution that can adapt to your changing needs.

Disadvantages of financing your accounts receivable

• Higher costs: Compared to most business loans, an accounts receivable financing loan/advance can often have a higher cost of borrowing, due to lenders’ risks of advancing funds against unpaid invoices.
• Customer perception fears: In factoring, the provider communicates with your customers about payments. Although common in certain sectors, this can make some businesses apprehensive about perception. Also, there’s a risk of strained client relationships if not handled carefully.
• Not suitable for all businesses: If you have low invoice volumes, unreliable customers or highly variable sales, your business might not be the best fit for accounts receivable financing.
• Limited scope: The amount you can borrow is limited to a percentage of the amount you’re owed. For businesses with larger financing requirements, other forms of funding may be more suitable and flexible.
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Tips for optimising your accounts receivable processes 

While financing accounts receivable can be a handy option for managing your cash flow, it shouldn’t paper over underlying issues. Businesses should consider how to improve credit controls, boost efficiency and not be overreliant on this finance facility. 

Here are a few tips to optimise accounts receivable processes alongside getting external finance support: 

1. Being careful with credit terms: Before extending credit to clients, check that they have a good track record of timely payments. Establish clear payment terms upfront, outlining due dates and any late fees, and take steps to encourage early payment, such as offering small discounts.
2. Invoicing on time: Fast and accurate invoicing is essential. Send invoices promptly after completing work or delivering goods, and ensure they're clear, concise, and easy for customers to understand. Offer a variety of payment options to make it convenient for customers to settle their accounts.
3. Leverage automation and smart accounting tools: Explore various accounting solutions that increase efficiency, such as automated alerts and workflows, dedicated invoicing chasing tools and predictive analytics.  
4. Working capital management: Beyond invoices, consider your working capital management big picture, including elements like negotiating better payment terms with suppliers, monitoring inventory levels to avoid tying up too much cash in stock and developing robust cash flow forecasting to anticipate potential shortfalls and plan accordingly.

Alternatives to accounts receivable financing

Weigh up the pros, cons and suitability factors of accounts receivable finance for your specific business needs. It’s not the only funding solution to support cash flow management and ease the pressure of lengthy payment schedules. 

Here are some of the main alternatives to accounts receivable financing to consider:

• Short-term business loans: Using a short-term loan from a digital lender, like iwoca, enables you to get fast and flexible access to working capital, with repayments tailored to your cash flow. They are often unsecured loans, meaning you don’t need to provide assets as collateral. However, you may need to provide a personal guarantee.
• Bridging loans: If your business is waiting for a big payment or asset sale, a bridging loan could be the answer. They provide short-term access to capital, often secured against an asset like property or equipment, but come with higher interest rates than traditional loans.
• Merchant cash advances (MCAs): For businesses with high credit and debit card sales but unpredictable cash flow (such as retailers), an MCA can be a viable option. As a form of revenue-based financing, lenders provide an advance based on your performance/forecasts to be repaid as a percentage of your future card sales.
• Line of credit financing: A line of credit is a revolving credit facility to draw from and repay as needed, a bit like a credit card. It's ideal for businesses with fluctuating cash flow or those who want ongoing access to working capital. You only pay interest on the amount you borrow, and it can help build your business credit.
• Business overdrafts: A business overdraft allows you to borrow a set amount beyond your account balance when needed. It's a good option for short-term cash flow issues and unexpected expenses, but while it offers flexibility, interest rates/fees can add up quickly if not managed carefully.

‍Flexible business finance for cash flow management

If you need more flexibility than accounts receivable financing offers and access to larger sums of capital, explore iwoca’s business loans. They are designed specifically for the needs of UK SMEs, supporting cash flow management and helping companies reach their growth ambitions. 

You can borrow between £1,000 and £1 million for a matter of days, weeks or months (up to 60 months), with affordable repayment terms, only paying interest on what you draw down, and options to pay back the loan early free of charge.

Apply for a loan from iwoca today and get a funding decision within 24 hours, or use our handy business loan calculator to see your likely repayments.