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 an Allowance for Doubtful Accounts?

An allowance for doubtful accounts is a contra account that nets against the total receivables presented on the balance sheet to reflect only the amounts expected to be paid. The allowance for doubtful accounts estimates the percentage of accounts receivable that are expected to be uncollectible. However, the actual payment behavior of customers may differ substantially from the estimate.

Understanding the Allowance for Doubtful Accounts

Regardless of company policies and procedures for credit collections, the risk of the failure to receive payment is always present in a transaction utilizing credit. Thus, a company is required to realize this risk through the establishment of the allowance for doubtful accounts and offsetting bad debt expense. In accordance with the matching principle of accounting, this ensures that expenses related to the sale are recorded in the same accounting period as the revenue is earned. The allowance for doubtful accounts also helps companies more accurately estimate the actual value of their account receivables.

Because the allowance for doubtful accounts is established in the same accounting period as the original sale, an entity does not know for certain which exact receivables will be paid and which will default. Therefore, generally accepted accounting principles (GAAP) dictate that the allowance must be established in the same accounting period as the sale, but can be based on an anticipated or estimated figure. The allowance can accumulate across accounting periods and may be adjusted based on the balance in the account.

How to Estimate the Allowance for Doubtful Accounts

Two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected.

Percentage of Sales Method

The sales method applies a flat percentage to the total dollar amount of sales for the period. For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense.

If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400.

Accounts Receivable Aging Method

The second method of estimating the allowance for doubtful accounts is the aging method. All outstanding accounts receivable are grouped by age, and specific percentages are applied to each group. The aggregate of all group results is the estimated uncollectible amount.

For example, a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on previous experience, 1% of accounts receivable less than 30 days old will be uncollectible, and 4% of those accounts receivable at least 30 days old will be uncollectible.

Therefore, the company will report an allowance of $1,900 (($70,000 * 1%) + ($30,000 * 4%)). If the next accounting period results in an estimated allowance of $2,500 based on outstanding accounts receivable, only $600 ($2,500 – $1,900) will be the adjusting entry amount.

Risk Classification Method

Some companies may classify different types of debt or different types of vendors using risk classifications. For example, a start-up customer may be considered a high risk, while an established, long-tenured customer may be a low risk. In this example, the company often assigns a percentage to each classification of debt. Then, it aggregates all receivables in each grouping, calculates each group by the percentage, and records an allowance equal to the aggregate of all products.

Historical Percentage Method

If a company has a history of recording or tracking bad debt, it can use the historical percentage of bad debt if it feels that historical measurement relates to its current debt. For example, a company may know that its 10-year average of bad debt is 2.4%. Therefore, it can assign this fixed percentage to its total accounts receivable balance since more often than not, it will approximately be close to this amount. The company must be aware of outliers or special circumstances that may have unfairly impacted that 2.4% calculation.

Pareto Analysis Method

A Pareto analysis is a risk measurement approach that states that a majority of activity is often concentrated among a small amount of accounts. In many different aspects of business, a rough estimation is that 80% of account receivable balances are made up of a small concentration (i.e. 20%) of vendors. This 80%/20% ratio is used throughout business.

Though the Pareto Analysis can not be used on its own, it can be used to weigh accounts receivable estimates differently. For example, a company may assign a heavier weight to the clients that make up a larger balance of accounts receivable due to conservatism.

Specific Identification Method

Assume a company has 100 clients and believes there are 11 accounts that may go uncollected. Instead of applying percentages or weights, it may simply aggregate the account balance for all 11 customers and use that figure as the allowance amount. Companies often have a specific method of identifying the companies that it wants to include and the companies it wants to exclude.

How to Account for the Allowance for Doubtful Accounts

Establishing the Allowance

The first step in accounting for the allowance for doubtful accounts is to establish the allowance. This is done by using one of the estimation methods above to predict what proportion of accounts receivable will go uncollected. For this example, let’s say a company predicts it will incur $500,000 of uncollected accounts receivable.

To create the allowance, the company must debit a loss. Most often, companies use an account called ‘Bad Debt Expense’. Then, the company establishes the allowance by crediting an allowance account often called ‘Allowance for Doubtful Accounts’. Though this allowance for doubtful accounts is presented on the balance sheet with other assets, it is a contra asset that reduces the balance of total assets.

• DR Bad Debt Expense $500,000
• CR Allowance for Doubtful Accounts $500,000

Adjusting the Allowance

Let’s say six months passes. The company now has a better idea of which account receivables will be collected and which will be lost. For example, say the company now thinks that a total of $600,000 of receivables will be lost. This means its allowance of $500,000 is $100,000 short. The company must record an additional expense for this amount to also increase the allowance’s credit balance.

• DR Bad Debt Expense $100,000
• CR Allowance for Doubtful Accounts $100,000

Writing Off Account

Now, let’s say a specific customer that owes a company $50,000 officially files for bankruptcy. This client’s account had previously been included in the estimate for the allowance. Because the company has a very low priority claim without collateral to the debt, the company decides it is unlikely it will every receive any of this $50,000. To properly reflect this change, the company must reduce its accounts receivable balance by this amount. On the other hand, once the receivable is removed from the books, there is no need to record an associated allowance for this account.

• DR Allowance for Doubtful Accounts $50,000
• CR Accounts Receivable $50,000

Note that the debit to the allowance for doubtful accounts reduces the balance in this account because contra assets have a natural credit balance. Also, note that when writing off the specific account, no income statement accounts are used. This is because the expense was already taken when creating or adjusting the allowance.

Recovering an Account

By miracle, it turns out the company ended up being rewarded a portion of their outstanding receivable balance they’d written off as part of the bankruptcy proceedings. Of the $50,000 balance that was written off, the company is notified that they will receive $35,000.

The company can recover the account by reversing the entry above to reinstate the accounts receivable balance and the corresponding allowance for doubtful account balance. Then, the company will record a debit to cash and credit to accounts receivable when the payment is collected. You’ll notice that because of this, the allowance for doubtful accounts increases. A company can further adjust the balance by following the entry under the “Adjusting the Allowance” section above.

• DR Accounts Receivable $35,000
• CR Allowance for Doubtful Accounts $35,000
• DR Cash $35,000
• CR Accounts Receivable $35,000

The Bottom Line

The allowance for doubtful accounts is a general ledger account that is used to estimate the amount of accounts receivable that will not be collected. A company uses this account to record how many accounts receivable it thinks will be lost. The balance may be estimated using several different methods, and management should periodically evaluate the balance of the allowance account to ensure the appropriate bad debt expense and net accounts receivables are being recorded.

What Are Accounts Receivable (AR)?

Accounts receivable (AR) are the balance of money due to a firm for goods or services delivered or used but not yet paid for by customers. Accounts receivable are listed on the balance sheet as a current asset. Any amount of money owed by customers for purchases made on credit is AR.

Understanding Accounts Receivable

Accounts receivable refer to the outstanding invoices that a company has or the money that clients owe the company. The phrase refers to accounts that a business has the right to receive because it has delivered a product or service. Accounts receivable, or receivables, represent a line of credit extended by a company and normally have terms that require payments due within a relatively short period. It typically ranges from a few days to a fiscal or calendar year.

Companies record accounts receivable as assets on their balance sheets because there is a legal obligation for the customer to pay the debt. They are considered a liquid asset, because they can be used as collateral to secure a loan to help meet short-term obligations. Receivables are part of a company’s working capital.

Furthermore, accounts receivable are current assets, meaning that the account balance is due from the debtor in one year or less. If a company has receivables, this means that it has made a sale on credit but has yet to collect the money from the purchaser. Essentially, the company has accepted a short-term IOU from its client.

Accounts Receivable vs. Accounts Payable

When a company owes debts to its suppliers or other parties, these are accounts payable. Accounts payable are the opposite of accounts receivable. To illustrate, imagine Company A cleans Company B’s carpets and sends a bill for the services. Company B owes them money, so it records the invoice in its accounts payable column. Company A is waiting to receive the money, so it records the bill in its accounts receivable column.

Benefits of Accounts Receivable

Accounts receivable are an important aspect of a business’s fundamental analysis. Accounts receivable are a current asset, so it measures a company’s liquidity or ability to cover short-term obligations without additional cash flows. 

Fundamental analysts often evaluate accounts receivable in the context of turnover, also known as accounts receivable turnover ratio, which measures the number of times a company has collected on its accounts receivable balance during an accounting period. Further analysis would include assessing days sales outstanding (DSO), the average number of days that it takes to collect payment after a sale has been made.

Example of Accounts Receivable

An example of accounts receivable includes an electric company that bills its clients after the clients received the electricity. The electric company records an account receivable for unpaid invoices as it waits for its customers to pay their bills. 

Most companies operate by allowing a portion of their sales to be on credit. Sometimes, businesses offer this credit to frequent or special customers that receive periodic invoices. The practice allows customers to avoid the hassle of physically making payments as each transaction occurs. In other cases, businesses routinely offer all of their clients the ability to pay after receiving the service.