Accounts receivable financing involves the sale of one’s accounts receivable in exchange for a working capital loan. Receivables are considered a highly liquid asset, and so are one of the best forms of collateral for loans. The amount loaned is somewhat less than the amount of the receivables being used as collateral, which can be up to 90% of the face value of the receivables. Customers are instructed to send their payments to the lender, which extracts the amount of its loan and any associated fees and interest charges, and then forwards the residual amount to the borrower. The risk of receivable default is transferred to the lender, since it is buying the receivables. Because of this risk, the lender may only accept receivables from larger and more creditworthy customers of the borrower.
Because of the high level of paperwork involved in the arrangement and the risk of customer defaults, the interest rate associated with this type of financing is quite high. Consequently, it is typically only used by businesses that cannot enter into more reasonably-priced lending arrangements. The type of business that will find accounts receivable financing to be most attractive are those with little available cash and rapid growth; they need to finance an expanding amount of receivables, but do not have the cash to pay for the underlying inventory.
A downside of receivable financing is that customers may learn about the arrangement, since they are being asked to send their payments to a different address. This issue can be mitigated by characterizing the payments as going to a lockbox for cash management purposes.