Factoring is a type of asset based financing that is often confused with asset based lending. While these products have some similarities, they are very different. This article helps you understand the differences between these products and helps you determine which one is best suited for your company.
1. What is asset based lending?
An Asset Based Loan (ABL) is a loan or line of credit that is secured using company assets as collateral. The collateral used for security often includes accounts receivable, inventory, equipment, and other assets. Most asset based loans are structured as lines of credit. They allow the company to draw funds to pay corporate expenses or make new investments.
The lender uses the value of the assets to determine a borrowing base – essentially the amount of money you can borrow. The borrowing base is usually a percentage of the market value of these assets. ABL lenders often provide a loan-to-value (LTV) ratio of 75% to 90% for accounts receivable. Other collateral, such as inventory or equipment, is financed at a lower LTV, usually 50% or less.
The borrowing base is updated regularly to reflect changes in asset value. For example, new invoices that are created and old invoices that are paid can change the available borrowing base.
2. What is factoring?
Invoice factoring is a type of business financing in which a factoring company purchases accounts receivable in exchange for an immediate payment. This payment provides liquidity to the client. Factoring helps companies that have cash flow problems because they cannot wait the usual 30 to 90 days for customers to pay invoices.
While factoring transactions can resemble the function of a line of credit, they are often structured as an actual sale. The finance company purchases each invoice through a purchase and sale agreement. As part of the purchasing process, the finance company notifies the payer of the purchase and verifies the accuracy of the invoice. Learn more about invoice factoring.
3. Differences between factoring and asset based loans
On the surface, asset based loans and factoring programs can look and behave similarly because both programs can provide similar benefits. However, these products have important differences.
a) Risk level
Factoring is provided to new and growing companies that can’t qualify for conventional bank financing. Therefore, factoring is considered a riskier form of financing from the lender’s perspective.
Asset based loans, on the other hand, are provided to larger and more established companies. While these companies still many not qualify for bank financing, they are well on their way to being “bankable.”
Most asset based loans start with a borrowing base of $700,000 and can reach as high as a few million dollars. Factoring lines, on the other hand, have no minimums and can work with small businesses and startups.
Cost is one important difference between these products. Generally, asset based loans are substantially cheaper than invoice factoring lines. Factoring lines are priced by discounting the full value of the invoice by a percentage. Discounts range from 1.15% to 3.5% per 30 days.
Asset based loans, on the other hand, are priced with an annual percentage rate (APR). The APR on an ABL can range from 7% to 15%. However, many variables, such as risk and line size, can impact the final costs.
d) Customer contact and interactions
Factoring lines require a high level of interaction between the factoring company and the customer paying the invoice. As mentioned before, customers are notified and invoices are verified regularly to ensure that the invoices being purchased are accurate. Consequently, your customers will know that you are using accounts receivable factoring. This aspect of factoring is not necessarily a problem, but it is something you should be aware of.
Asset based lenders don’t have any substantial contact with your customers. They may verify some invoices, but, usually, your customers will not know you are using the facility.
e) Due diligence
Most factoring facilities require minimal due diligence. Often, the factoring company reviews the client’s financials and performs a collateral search. With few exceptions, this review can be done in a day or two and is inexpensive.
Asset based loans, due to their larger size and structure, require substantially more due diligence. Lenders usually perform collateral checks and audits to review the accounting ledgers. Most ABL providers charge a few thousand dollars for this process, though costs vary.
4. Similarities between factoring and asset based lending
One important similarity between these products is how customer payments are handled. Since accounts receivable are the main collateral backing both transactions types, customers mail payments to a lockbox controlled by the lender. Customer payments are used to settle the transactions.
Note that payments sent to lockboxes can be made in the client’s name. Therefore, the payment is mailed in your name to the lockbox address, and the check can be made to your name as well.
Consequently, using a lockbox does not necessarily alert your customers that you are using an ABL or a factoring line.
5. Which product is best for your company?
Most companies prefer to use asset based loans over factoring due to flexibility. However, asset based loans tend to have high due diligence costs and are available only to companies that meet their size and collateral requirements.
Alternatively, factoring is available to companies of all sizes, has minimal due diligence costs, and is relatively easy to get.
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