It’s not unusual for small and midsize businesses to experience cash flow problems from time to time. As a matter of fact, many growing businesses encounter financial problems as a result of their fast growth. Often, the only way to improve cash flow and fix the problem is to use financing.
Two common financing solutions that help improve cash flow are lines of credit and invoice factoring. This article helps you understand both products, along with their advantages and disadvantages. This information enables you to select the solution that is best for your business.
How does a business line of credit work?
A line of credit works much like a credit card. The lending institution provides you with a maximum credit limit. Whenever your business needs money to pay expenses, you request a draw from the line. This draw provides you with funds, but it reduces your available credit. When you remit a payment to repay the line, your available credit increases.
Lenders provide lines of credit based on the three Cs: collateral, cash flow, and credit. They expect that your business has the collateral to secure the line and the cash flow to make payments as needed. Lines also have covenants – contractual provisions that you must follow to keep the line operational. Lastly, it is not unusual for lines to be secured by both corporate and personal assets. Learn more detailed information about lines of credit.
How does invoice factoring work?
One of the main reasons why business owners have cash flow problems is that they have to offer payment terms to clients. These terms give clients 30, 40, or even 60 days to pay. The problem is that growing businesses can’t afford to wait that long for payment. And if businesses demand immediate payments and don’t offer terms, they risk losing clients.
Invoice factoring allows your company to sell your invoices to a factoring company. The factoring company provides you with an immediate payment, while they wait to get paid by your customer.
Factoring companies usually finance invoices in two installment payments. The first installment covers up to 85% of the invoice and is paid as soon as you factor the invoice. The remaining 15%, less their discount fee, is paid once your client pays the invoice in full. The line is revolving, which means that you can finance invoices on an ongoing basis. Learn more about invoice factoring.
Factoring vs. Line of Credit
In this section, we compare both products across the eight most important product features.
1. Cost: Lines of credit are cheaper
Lines of credit are one of the cheapest forms of financing in the market. Generally, lines are priced based on the prime rate, plus an incremental portion. The price often looks like this: “prime rate + X%”, where “X%” is the incremental portion.
Factoring lines, on the other hand, tend to cost more. Consequently, they work best for companies whose profit margins are high. In general, profit margins at or above 15% work well. However, in some cases, factoring can work with lower margin transactions.
2. Qualification: Getting a line of credit can be difficult
Lines of credit have stringent qualification requirements. Credit lines are a low-cost solution because lenders work with low-risk clients. Companies usually need to have a couple of years’ worth of operating experience. They must have enough cash flow and assets to repay the line. Lastly, the owners usually need to have good credit. In some cases, personal assets may have to be pledged as collateral.
The qualification requirements for invoice factoring are much easier. The most important requirement is that the company (your customer) paying the invoice must have good commercial credit. Aside from that, your company must not be at risk of an immediate bankruptcy and your accounts receivable must be free of UCC liens.
3. Time frame: Lines of credit can take weeks (or months) to get
The time it takes to open a line of credit varies. It can take a couple of weeks or a couple of months. It really depends on how quickly you can provide information to your lender and how long the lender takes to evaluate it.
In general, factoring lines can be established in a week or two.
4. Credit limit: Factoring has flexible credit limits
The credit limit of a line of credit is set by a combination of your need, your available cash flow, and your assets. However, lenders expect to be fully covered by your cash flow and collateral and take those into consideration when setting the credit limit.
The credit limit of a factoring line is determined by a combination of the amount of accounts receivable you have from creditworthy customers, your ability to deliver services/products to your clients, and your needs.
5. Maintenance: Lines of credit can be hard to maintain
Most lines of credit come with covenants, which are rules that your company must follow in order to keep the credit line in place. Covenants vary by lender but usually the require that your company:
- Maintain good financial records
- Keep accurate track of inventory
- Keep a certain net worth
- Keep financial ratios at a certain level
- Advise the lender of any material changes
Most factoring lines do not have covenants. All you have to do to keep an invoice factoring line in place is avoid a material default (e.g., bankruptcy) and finance invoices for completed work payable by commercially creditworthy clients.
6. Access to funds: Getting funds is relatively easy for both solutions
To access the funds from your line of credit, you usually submit a draw request to the financial institution, which is honored fairly quickly. Depending on the specific product, you can either submit a borrowing base certificate or draw from the loan account.
To get an advance from your factoring line, you must submit a schedule of accounts to the factor. The request must include a tally of the invoices you want to finance, along with copies of the invoices.
7. Line increases: You can increase your factoring credit limit quickly
The process to increase the credit limit of a factoring line is simple. You have to provide the factoring company with information about the anticipated customers and expected volume. The process usually takes a day or so. As long as your account is in good standing and the new customers meet the factoring company’s criteria, your chances of getting an increase are good.
Getting an increase on a line of credit is more complicated. Your company must have the cash flow and the assets to justify the increase. Also, your line must have been in place for a certain time – often a year – before you can request an increase. Lastly, the lender may need to repeat part of its underwriting, which can take a few weeks.
8. Collateral: Both products require collateral
Most lines of credit need to use all your corporate assets as collateral. Lenders do make exceptions that are handled on a case-by-case basis.
At a minimum, a factoring company needs to have your accounts receivable as collateral. However, some factoring companies request more. There is some flexibility here, as long as the accounts receivable is clear of liens.
Which solution is best?
There is no best solution per se. Each product is good at solving a specific set of problems. Remember that no product is perfect.
Consider factoring if your business:
- Is relatively new
- Is growing quickly
- Has very good commercial clients that pay within 60 days
- Has (or had) financial problems
- Cannot produce accurate financial reports
- Is out of covenant with an existing line of credit
Consider a line of credit if your business:
- Is established
- Has achieved growth maturity
- Can provide timely and accurate financial statements
- Has solid assets
- Can abide by the line of credit covenants
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