What Is Accounts Receivable Financing?

Accounts receivable (AR) financing is a type of financing arrangement in which a company receives financing capital related to a portion of its accounts receivable. Accounts receivable financing agreements can be structured in multiple ways usually with the basis as either an asset sale or a loan.

Understanding Accounts Receivable Financing

Accounts receivable financing is an agreement that involves capital principal in relation to a company’s accounts receivables. Accounts receivable are assets equal to the outstanding balances of invoices billed to customers but not yet paid. Accounts receivables are reported on a company’s balance sheet as an asset, usually a current asset with invoice payment required within one year.

Accounts receivable are one type of liquid asset considered when identifying and calculating a company’s quick ratio which analyzes its most liquid assets:

Quick Ratio = (Cash Equivalents + Marketable Securities + Accounts Receivable Due within One Year) / Current Liabilities

As such, both internally and externally, accounts receivable are considered highly liquid assets which translate to theoretical value for lenders and financiers. Many companies may see accounts receivable as a burden since the assets are expected to be paid but require collections and can’t be converted to cash immediately. As such, the business of accounts receivable financing is rapidly evolving because of these liquidity and business issues. Moreover, external financiers have stepped in to meet this need.

The process of accounts receivable financing is often known as factoring and the companies that focus on it may be called factoring companies. The best factoring companies will usually focus substantially on the business of accounts receivable financing but factoring in general may be a product of any financier. Financiers may be willing to structure accounts receivable financing agreements in different ways with a variety of different potential provisions.​

Structuring

Accounts receivable financing is becoming more common with the development and integrations of new technologies that help to link business accounts receivable records to accounts receivable financing platforms. In general, accounts receivable financing may be slightly easier for a business to obtain than other types of capital financing. This can be especially true for small businesses that easily meet accounts receivable financing criteria or for large businesses that can easily integrate technology solutions.

Overall, there are a few broad types of accounts receivable financing structures.

Asset Sales

Accounts receivable financing is typically structured as an asset sale. In this type of agreement, a company sells accounts receivable to a financier. This method can be similar to selling off portions of loans often done by banks.

A business receives capital as a cash asset replacing the value of the accounts receivable on the balance sheet. A business may also need to take a write-off for any unfinanced balances which would vary depending on the principal to value ratio agreed on in the deal.

Depending on the terms, a financier may pay up to 90% of the value of outstanding invoices. This type of financing may also be done by linking accounts receivable records with an accounts receivable financier. Most factoring company platforms are compatible with popular small business bookkeeping systems such as Quickbooks. Linking through technology helps to create convenience for a business, allowing them to potentially sell individual invoices as they are booked, receiving immediate capital from a factoring platform.

With asset sales, the financier takes over the accounts receivable invoices and takes responsibility for collections. In some cases, the financier may also provide cash debits retroactively if invoices are fully collected.

Most factoring companies will not be looking to buy defaulted receivables, rather focusing on short-term receivables. Overall, buying the assets from a company transfers the default risk associated with the accounts receivables to the financing company, which factoring companies seek to minimize.

In asset sale structuring, factoring companies make money on the principal to value spread. Factoring companies also charge fees which make factoring more profitable to the financier.

BlueVine is one of the leading factoring companies in the accounts receivable financing business. They offer several financing options related to accounts receivable including asset sales. The company can connect to multiple accounting software programs including QuickBooks, Xero, and Freshbooks. For asset sales, they pay approximately 90% of a receivables value and will pay the rest minus fees once an invoice has been paid in full. 

Loans

Accounts receivable financing can also be structured as a loan agreement. Loans can be structured in various ways based on the financier. One of the biggest advantages of a loan is that accounts receivable are not sold. A company just gets an advance based on accounts receivable balances. Loans may be unsecured or secured with invoices as collateral. With an accounts receivable loan, a business must repay.

Companies like Fundbox, offer accounts receivable loans and lines of credit based on accounts receivable balances. If approved, Fundbox can advance 100% of an accounts receivable balance. A business must then repay the balance over time, usually with some interest and fees.

Accounts receivable lending companies also benefit from the advantage of system linking. Linking to a companies accounts receivable records through systems such as QuickBooks, Xero, and Freshbooks, can allow for immediate advances against individual invoices or management of line of credit limits overall.

Underwriting

Factoring companies take several elements into consideration when determining whether to onboard a company onto its factoring platform. Furthermore, the terms of each deal and how much is offered in relation to accounts receivable balances will vary.

Accounts receivables owed by large companies or corporations may be more valuable than invoices owed by small companies or individuals. Similarly, newer invoices are usually preferred over older invoices. Typically, the age of receivables will heavily influence the terms of a financing agreement with shorter term receivables leading to better terms and longer term or delinquent receivables potentially leading to lower financing amounts and lower principal to value ratios.

Advantages and Disadvantages

Accounts receivable financing allows companies to get instant access to cash without jumping through hoops or dealing with long waits associated with getting a business loan. When a company uses its accounts receivables for asset sales it does not have to worry about repayment schedules. When a company sells its accounts receivables it also does not have to worry about accounts receivable collections. When a company receives a factoring loan, it may be able to obtain 100% of the value immediately.

Although accounts receivable financing offers a number of diverse advantages, it also can carry a negative connotation. In particular, accounts receivable financing can cost more than financing through traditional lenders, especially for companies perceived to have poor credit. Businesses may lose money from the spread paid for accounts receivables in an asset sale. With a loan structure, the interest expense may be high or may be much more than discounts or default write-offs would amount to.

What Is the Accounting Rate of Return (ARR)?

The accounting rate of return (ARR) is a formula that reflects the percentage rate of return expected on an investment or asset, compared to the initial investment’s cost. The ARR formula divides an asset’s average revenue by the company’s initial investment to derive the ratio or return that one may expect over the lifetime of an asset or project. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.

Understanding the Accounting Rate of Return (ARR)

The accounting rate of return is a capital budgeting metric that’s useful if you want to calculate an investment’s profitability quickly. Businesses use ARR primarily to compare multiple projects to determine the expected rate of return of each project, or to help decide on an investment or an acquisition.

ARR factors in any possible annual expenses, including depreciation, associated with the project. Depreciation is a helpful accounting convention whereby the cost of a fixed asset is spread out, or expensed, annually during the useful life of the asset. This lets the company earn a profit from the asset right away, even in its first year of service.

The Formula for ARR

The formula for the accounting rate of return is as follows:

$ARR = \frac{Average\, Annual\, Profit}{Initial\, Investment}$ARR=InitialInvestmentAverageAnnualProfit​

How to Calculate the Accounting Rate of Return (ARR)

1. Calculate the annual net profit from the investment, which could include revenue minus any annual costs or expenses of implementing the project or investment.
2. If the investment is a fixed asset such as property, plant, and equipment (PP&E), subtract any depreciation expense from the annual revenue to achieve the annual net profit.
3. Divide the annual net profit by the initial cost of the asset or investment. The result of the calculation will yield a decimal. Multiply the result by 100 to show the percentage return as a whole number.

Example of the Accounting Rate of Return (ARR)

As an example, a business is considering a project that has an initial investment of $250,000 and forecasts that it would generate revenue for the next five years. Here’s how the company could calculate the ARR:

• Initial investment: $250,000
• Expected revenue per year: $70,000
• Time frame: 5 years
• ARR calculation: $70,000 (annual revenue) / $250,000 (initial cost)
• ARR = 0.28 or 28%

Accounting Rate of Return vs. Required Rate of Return

The ARR is the annual percentage return from an investment based on its initial outlay of cash. Another accounting tool, the required rate of return (RRR), also known as the hurdle rate, is the minimum return an investor would accept for an investment or project that compensates them for a given level of risk.

The RRR can vary between investors as they each have a different tolerance for risk. For example, a risk-averse investor likely would require a higher rate of return to compensate for any risk from the investment. It’s important to utilize multiple financial metrics including ARR and RRR to determine if an investment would be worthwhile based on your level of risk tolerance.

Advantages and Disadvantages of the Accounting Rate of Return (ARR)

Advantages

The accounting rate of return is a simple calculation that does not require complex math and is helpful in determining a project’s annual percentage rate of return. Through this, it allows managers to easily compare ARR to the minimum required return. For example, if the minimum required return of a project is 12% and ARR is 9%, a manager will know not to proceed with the project.

ARR comes in handy when investors or managers need to quickly compare the return of a project without needing to consider the time frame or payment schedule but rather just the profitability or lack thereof.

Disadvantages

Despite its advantages, ARR has its limitations. It doesn’t consider the time value of money. The time value of money is the concept that money available at the present time is worth more than an identical sum in the future because of its potential earning capacity.

In other words, two investments might yield uneven annual revenue streams. If one project returns more revenue in the early years and the other project returns revenue in the later years, ARR does not assign a higher value to the project that returns profits sooner, which could be reinvested to earn more money.

The accounting rate of return does not consider the increased risk of long-term projects and the increased uncertainty associated with long periods.

Also, ARR does not take into account the impact of cash flow timing. Let’s say an investor is considering a five-year investment with an initial cash outlay of $50,000, but the investment doesn’t yield any revenue until the fourth and fifth years.

In this case, the ARR calculation would not factor in the lack of cash flow in the first three years, while in reality, the investor would need to be able to withstand the first three years without any positive cash flow from the project.

The Bottom Line

The accounting rate of return (ARR) is a simple formula that allows investors and managers to determine the profitability of an asset or project. Because of its ease of use and determination of profitability, it is a handy tool in making decisions. However, the formula does not take into consideration the cash flows of an investment or project, the overall timeline of return, and other costs, which help determine the true value of an investment or project.

What Is Annual Percentage Rate (APR)?

Annual percentage rate (APR) refers to the yearly interest generated by a sum that’s charged to borrowers or paid to investors. APR is expressed as a percentage that represents the actual yearly cost of funds over the term of a loan or income earned on an investment. This includes any fees or additional costs associated with the transaction but does not take compounding into account. The APR provides consumers with a bottom-line number they can compare among lenders, credit cards, or investment products.

How the Annual Percentage Rate (APR) Works

An annual percentage rate is expressed as an interest rate. It calculates what percentage of the principal you’ll pay each year by taking things such as monthly payments and fees into account. APR is also the annual rate of interest paid on investments without accounting for the compounding of interest within that year.

The Truth in Lending Act (TILA) of 1968 mandates that lenders disclose the APR they charge to borrowers. Credit card companies are allowed to advertise interest rates on a monthly basis, but they must clearly report the APR to customers before they sign an agreement.

How Is APR Calculated?

APR is calculated by multiplying the periodic interest rate by the number of periods in a year in which it was applied. It does not indicate how many times the rate is actually applied to the balance.

$\begin{aligned} &\text{APR} = \left ( \left ( \frac{ \frac{ \text{Fees} + \text{Interest} }{ \text {Principal} } }{ n } \right ) \times 365 \right ) \times 100 \\ &\textbf{where:} \\ &\text{Interest} = \text{Total interest paid over life of the loan} \\ &\text{Principal} = \text{Loan amount} \\ &n = \text{Number of days in loan term} \\ \end{aligned}$​APR=((nPrincipalFees+Interest​​)×365)×100where:Interest=Total interest paid over life of the loanPrincipal=Loan amountn=Number of days in loan term​

Types of APRs

Credit card APRs vary based on the type of charge. The credit card issuer may charge one APR for purchases, another for cash advances, and yet another for balance transfers from another card. Issuers also charge high-rate penalty APRs to customers for late payments or violating other terms of the cardholder agreement. There’s also the introductory APR—a low or 0% rate—with which many credit card companies try to entice new customers to sign up for a card.

Bank loans generally come with either fixed or variable APRs. A fixed APR loan has an interest rate that is guaranteed not to change during the life of the loan or credit facility. A variable APR loan has an interest rate that may change at any time.

The APR borrowers are charged also depends on their credit. The rates offered to those with excellent credit are significantly lower than those offered to those with bad credit.

APR vs. Annual Percentage Yield (APY)

Though an APR only accounts for simple interest, the annual percentage yield (APY) takes compound interest into account. As a result, a loan’s APY is higher than its APR. The higher the interest rate—and to a lesser extent, the smaller the compounding periods—the greater the difference between the APR and APY.

Imagine that a loan’s APR is 12%, and the loan compounds once a month. If an individual borrows $10,000, their interest for one month is 1% of the balance, or $100. That effectively increases the balance to $10,100. The following month, 1% interest is assessed on this amount, and the interest payment is $101, slightly higher than it was the previous month. If you carry that balance for the year, your effective interest rate becomes 12.68%. APY includes these small shifts in interest expenses due to compounding, while APR does not.

Here’s another way to look at it. Say you compare an investment that pays 5% per year with one that pays 5% monthly. For the first month, the APY equals 5%, the same as the APR. But for the second, the APY is 5.12%, reflecting the monthly compounding.

Given that an APR and a different APY can represent the same interest rate on a loan or financial product, lenders often emphasize the more flattering number, which is why the Truth in Savings Act of 1991 mandated both APR and APY disclosure in ads, contracts, and agreements. A bank will advertise a savings account’s APY in a large font and its corresponding APR in a smaller one, given that the former features a superficially larger number. The opposite happens when the bank acts as the lender and tries to convince its borrowers that it’s charging a low rate. A great resource for comparing both APR and APY rates on a mortgage is a mortgage calculator.

APR vs. APY Example

Let’s say that XYZ Corp. offers a credit card that levies interest of 0.06273% daily. Multiply that by 365, and that’s 22.9% per year, which is the advertised APR. Now, if you were to charge a different $1,000 item to your card every day and waited until the day after the due date (when the issuer started levying interest) to start making payments, you’d owe $1,000.6273 for each thing you bought.

To calculate the APY or effective annual interest rate—the more typical term for credit cards—add one (that represents the principal) and take that number to the power of the number of compounding periods in a year; subtract one from the result to get the percentage:

$\begin{aligned} &\text{APY} = (1 + \text{Periodic Rate} ) ^ n – 1 \\ &\textbf{where:} \\ &n = \text{Number of compounding periods per year} \\ \end{aligned}$​APY=(1+Periodic Rate)n−1where:n=Number of compounding periods per year​

In this case your APY or EAR would be 25.7%:

$\begin{aligned} &( ( 1 + .0006273 ) ^ {365} ) – 1 = .257 \\ \end{aligned}$​((1+.0006273)365)−1=.257​

If you only carry a balance on your credit card for one month’s period, you will be charged the equivalent yearly rate of 22.9%. However, if you carry that balance for the year, your effective interest rate becomes 25.7% as a result of compounding each day.

APR vs. Nominal Interest Rate vs. Daily Periodic Rate

An APR tends to be higher than a loan’s nominal interest rate. That’s because the nominal interest rate doesn’t account for any other expense accrued by the borrower. The nominal rate may be lower on your mortgage if you don’t account for closing costs, insurance, and origination fees. If you end up rolling these into your mortgage, your mortgage balance increases, as does your APR.

The daily periodic rate, on the other hand, is the interest charged on a loan’s balance on a daily basis—the APR divided by 365. Lenders and credit card providers are allowed to represent APR on a monthly basis, though, as long as the full 12-month APR is listed somewhere before the agreement is signed.

Disadvantages of Annual Percentage Rate (APR)

The APR isn’t always an accurate reflection of the total cost of borrowing. In fact, it may understate the actual cost of a loan. That’s because the calculations assume long-term repayment schedules. The costs and fees are spread too thin with APR calculations for loans that are repaid faster or have shorter repayment periods. For instance, the average annual impact of mortgage closing costs is much smaller when those costs are assumed to have been spread over 30 years instead of seven to 10 years.

APR also runs into some trouble with adjustable-rate mortgages (ARMs). Estimates always assume a constant rate of interest, and even though APR takes rate caps into consideration, the final number is still based on fixed rates. Because the interest rate on an ARM will change when the fixed-rate period is over, APR estimates can severely understate the actual borrowing costs if mortgage rates rise in the future.

Mortgage APRs may or may not include other charges, such as appraisals, titles, credit reports, applications, life insurance, attorneys and notaries, and document preparation. There are other fees that are deliberately excluded, including late fees and other one-time fees.

All this may make it difficult to compare similar products because the fees included or excluded differ from institution to institution. In order to accurately compare multiple offers, a potential borrower must determine which of these fees are included and, to be thorough, calculate APR using the nominal interest rate and other cost information.

The Bottom Line

The APR is the basic theoretical cost or benefit of money loaned or borrowed. By calculating only the simple interest without periodic compounding, the APR gives borrowers and lenders a snapshot of how much interest they are earning or paying within a certain period of time. If someone is borrowing money, such as by using a credit card or applying for a mortgage, the APR can be misleading because it only presents the base number of what they are paying without taking time into the equation. Conversely, if someone is looking at the APR on a savings account, it doesn’t illustrate the full impact of interest earned over time.

APRs are often a selling point for different financial instruments, such as mortgages or credit cards. When choosing a tool with an APR, be careful to also take into account the APY because it will prove a more accurate number for what you will pay or earn over time. Though the formula for your APR may stay the same, different financial institutions will include different fees in the principal balance. Be aware of what is included in your APR when signing any agreement.

What Is Asymmetric Information?

Asymmetric information, also known as “information failure,” occurs when one party to an economic transaction possesses greater material knowledge than the other party. This typically manifests when the seller of a good or service possesses greater knowledge than the buyer; however, the reverse dynamic is also possible. Almost all economic transactions involve information asymmetries.

Understanding Asymmetric Information

Asymmetric information exists in certain deals with a seller and a buyer whereby one party is able to take advantage of another. This is usually the case in the sale of an item. For example, if a homeowner wanted to sell their house, they would have more information about the house than the buyer. They might know some floorboards are creaky, the home gets too cold in winter, or that the neighbors are too loud; information that the buyer would not know until after they purchased the house. The buyer, then, might feel they paid too much for the house or would not have purchased it at all if they had this information beforehand.

Asymmetric information can also be viewed as the specialization and division of knowledge, as applied to any economic trade. For example, doctors typically know more about medical practices than their patients. After all, physicians have extensive medical school educational backgrounds that their patients generally don’t have. This principle equally applies to architects, teachers, police officers, attorneys, engineers, fitness instructors, and other trained professionals. Asymmetric information, therefore, is most often beneficial to an economy and a society in increasing efficiency.

Advantages and Disadvantages of Asymmetric Information

Advantages

Asymmetric information isn’t necessarily a bad thing. In fact, growing asymmetrical information is the desired outcome of a healthy market economy. As workers strive to become increasingly specialized in their chosen fields, they become more productive, and can consequently provide greater value to workers in other fields.

For example, a stockbroker’s knowledge is more valuable to a non-investment professional, such as a farmer, who may be interested in confidently trading stocks to prepare for retirement. On the flip side, the stockbroker does not need to know how to grow crops or tend to livestock to feed themself, but rather can purchase the items from a grocery store that are provided by the farmer.

In each of their respective trades, both the farmer and the stockbroker hold superior knowledge over the other, but both benefit from the trade and the division of labor.

One alternative to ever-expanding asymmetric information is for workers to study all fields, rather than specialize in fields where they can provide the most value. However, this is an impractical solution, with high opportunity costs and potentially lower aggregate outputs, which would lower standards of living.

Disadvantages

In some circumstances, asymmetric information may have near fraudulent consequences, such as adverse selection, which describes a phenomenon where an insurance company encounters the probability of extreme loss due to a risk that was not divulged at the time of a policy’s sale.

For example, if the insured hides the fact that they’re a heavy smoker and frequently engage in dangerous recreational activities, this asymmetrical flow of information constitutes adverse selection and could raise insurance premiums for all customers, forcing the healthy to withdraw. The solution is for life insurance providers to perform thorough actuarial work and conduct detailed health screenings, and then charge different premiums to customers based on their honestly disclosed risk profiles.

Special Considerations

To prevent abuse of customers or clients by finance specialists, financial markets often rely on reputation mechanisms. Financial advisors and fund companies that prove to be the most honest and effective stewards of their clients’ assets tend to gain clients, while dishonest or ineffective agents tend to lose clients, face legal damages, or both.