Running a construction business is tricky. You furnish materials or labor to a project, but the payment for them does not come right away. It often takes months before invoices get paid, and so maintaining a steady cash flow can be a difficult challenge.
There are multiple funding options available for construction businesses that want to keep a steady source of cash, especially during the slow season. Choosing the correct funding method depends on various factors, including the size of your business and even the credit ratings of your clients. An accounts receivable line of credit is a funding method that can be beneficial to different types of businesses. Like most funding solutions, accounts receivable or AR line of credit gives you access to immediate cash whenever you need it.
If you’re considering applying for an accounts receivable line of credit, this guide will explain its basic operations and help you decide if this is the best funding option that suits your business.
- What is an accounts receivable line of credit?
- How is an accounts receivable line of credit different from other financing options?
- Advantages of using an accounts receivable line of credit
- Disadvantages of using an accounts receivable line of credit
What is an accounts receivable line of credit?
An accounts receivable line of credit is a form of financing in which a lender gives you access to a pool of money from which you can withdraw at any time. Access to this funding is given in exchange for your accounts receivables or the expected payment for your invoices.
When you are approved for an accounts receivable line of credit, the lender either buys your accounts receivables or uses them as collateral and then they give you a predetermined amount of money that you can use whenever you need immediate cash.
How does an accounts receivable line of credit work?
An accounts receivable line of credit works like a typical bank line of credit, only your accounts receivables are on the line. When you have an AR line of credit, the lender gives you a limited pool of money that you can use whenever you need it. You may withdraw from this pool of money at any time, but it also follows that the more money you take, the smaller your pool of money becomes.
How you repay the money that you withdraw depends on your agreement with the lender. Some lenders implement an accounts receivable line of credit by buying your invoices in bulk. You essentially sell them your invoices, they give you access to a predetermined amount of cash, and they take care of collecting the payment of your invoices.
There are also lenders who implement the AR line of credit by giving you the same access to a pool of funding and using your accounts receivables as collateral. This means that you are expected to pay back the amount of money that you borrow at regular intervals, just like a traditional line of credit from a bank. If you fail to pay the loan back, the lender has the right to recover their money from your accounts receivables.
How is an accounts receivable line of credit different from other financing options?
Accounts receivable line of credit vs. traditional bank line of credit
An AR line of credit works the same way as a traditional line of credit from a banking institution. In AR line of credit, however, your accounts receivables act as security for the lender.
Most banking institutions offer a business line of credit to companies that have good credit ratings and they require no collateral. With an AR line of credit, you use your accounts receivables in exchange for getting access to a pool of money that lenders will loan you. You either sell the lender all your invoices and they give you the pool of funding as advanced payment, or you use your invoices as collateral if you fail to pay the lender back.
Because a business line of credit from a traditional banking institution is a form of an “unsecured” loan, it requires a more stringent approval process. An AR line of credit from a lending institution is relatively easier to get, although your invoices and financial status still have to be of good quality.
Accounts receivable line of credit vs. invoice factoring
An accounts receivable line of credit and invoice factoring are often used interchangeably; however, these two are not exactly the same.
With invoice factoring, you sell your invoices and you also get advanced payment from the lender. However, invoice factoring typically requires the lender to disclose their role as a factoring company when collecting payment from your clients. With an AR line of credit, such disclosure is not necessarily required.
Invoice factoring is also a more feasible option for smaller businesses that do not yet have sizeable accounts receivable from established clients. Invoice factoring may be done in small batches of accounts receivables, while qualifying for an AR line of credit typically involves larger sums of invoices that go up to millions.
Accounts receivable line of credit vs. asset-based financing
An accounts receivable line of credit is a type of asset-based financing, but it is more specific. The money that you borrow from a lender is given as a line of credit, and the asset that you utilize must be your accounts receivables or your invoices.
Asset-based financing may involve other types of assets such as real estate, machinery, and equipment. An AR line of credit only uses your invoices as collateral or as security for the lender, although some lenders may require that you also put other assets on the line before they can approve you for an AR line of credit.
Advantages of using an accounts receivable line of credit
1. Immediate access to money
An AR line of credit is a good way to have access to cash immediately. It will help you fund an unexpected purchase such as new equipment, for example, and it can cover for your financial needs during slow business season.
Because you are given access to a pool of money, you do not have to spend your funding all at once. Having an AR line of credit is like having a steady back-up plan in cases of financial emergencies.
2. Flexible payment terms and agreements
Unlike other loans, an AR line of credit can allow you to pay for only the money that you borrow. Depending on your agreement with your lender, you may not have to pay anything back if you do not withdraw any amount from your line of credit. This makes an AR line of credit a more preferable option than other financing methods. Some lending institutions require that you pay the full amount at regular intervals, but an AR line of credit can offer more flexibility in terms of spending and repayment.
3. No physical assets required for collateral
You may qualify for an AR line of credit without risking the loss of your other assets, such as real estate or machinery. This is an advantage for companies that would rather preserve ownership over their other assets than put them on the line.
Note, however, that some lending companies may ask that you still use your other assets as collateral. This depends on your credit status as a company and the quality of the accounts receivables.
Disadvantages of using an accounts receivable line of credit
1. Low-quality invoices are typically not accepted
An AR line of credit requires that you use your invoices as security for the lender, so your invoices have to be of good quality. This means that your invoices must be worth a significant amount of money and your clients must have good credit ratings.
2. Long durations of contracts
Because an accounts receivable line of credit gives you access to a pool of money that you may use at any time, you are also expected to get into a relatively lengthy contract with a lender. This makes an AR line of credit not a suitable option for businesses that are only looking to get a loan for a one-time expense.
3. Difficulty of qualifying
An accounts receivable line of credit is not as easy to get, especially for businesses that are just starting out. You usually need a reliable client base and a sizeable amount of accounts receivables before you can use your invoices as security for lenders who are willing to give you access to a huge sum of money.