As a business owner, you want to use the right financing tool to solve your problems. This article helps you do that. We compare two common business financing tools: business cash advances and invoice factoring. This article helps you determine if either solution is right for you. In this article, you learn:
- What a cash advance is
- What invoice factoring is
- Product comparison against 7 criteria
- Risks associated with each product
What is a business cash advance?
A business cash advance is a product that provides a “loan” against your future sales. They are also known as merchant cash advances (MCAs). These loans are for a fixed amount of money and usually for a short term (months). They can be used for any business purpose.
The loan is paid through a daily or weekly debit from your bank account. Learn more about business cash advances and how they work.
Note: We use the term “loan” to define a cash advance for simplicity. Courts are still determining whether it is a true loan or the purchase of future receivables.
What is factoring?
Factoring is a tool that finances your current net-30 to net-90 client invoices. Instead of waiting to get paid by clients, you arrange for the factor to advance funds to you quickly.
You can use those funds for any business expense. Most companies use factoring to pay recurring expenses such as employees, operations, and suppliers.
Factoring is structured as an ongoing solution designed to improve cash flow. It can finance all or some of your invoices, based on your needs. Factoring lines can grow with your sales.
What problem are you trying to solve?
The first thing you should do before looking for financing is define your problem. What problem are you trying to solve? The financing solution you select should fit the problem you want to solve. Otherwise, you will have problems.
Factoring is a great solution if you are dealing with ongoing costs. As mentioned before, you can use factoring to cover payroll. You can also use it to pay suppliers, rent, and other expenses.
However, factoring is not the best solution to cover large, one-time expenses such as buying machinery or equipment. A specialized term loan product is usually a better alternative.
Business cash advance vs. factoring
In this section, we compare merchant cash advances and factoring against the following seven metrics:
Invoice factoring is very effective at solving cash flow problems – specifically, problems created by recurring, slow-paying commercial clients.
A term-loan type program is better at helping to cover one-time company expenses or projects such as machinery, equipment, etc. These products can also be used to fulfill large inventory for special projects.
b) Application process
In general, both products have relatively simple application processes. However, business cash advances require less documentation.
c) Speed of funding
Most factoring lines take about a week from application to first funding. Fundings after the initial invoice are usually done in one business day. On the other hand, most cash advances can be funded within a couple of days.
d) Handling growth
Factoring lines are adaptive. They can easily be increased to handle additional sales.
Merchant cash advances usually can’t be increased. You will need to get a new advance large enough to close your existing line and meet your new requirements. When this process is done incorrectly, it can lead to serious financial problems. This issue is discussed in the “Know the risks!” section.
e) Available to startups
Invoice factoring can be used by brand new companies. Business cash advances require a history of 3 to 6 months (varies by provider).
f) Cost of funds
Comparing the cost of factoring with the cost of a cash advance can be difficult. Both products have different structures. In general, the cost of factoring ranges from 1.25% to 3.5% per every 30 days that the invoice is open.
The costs of an MCA are based on applying a multiplier to the total loan. This multiplier can range from 1.15 to 1.40 (115% to 140%). For example, assume a $100,000 loan with a 1.25 (125%) multiplier. The total payback (i.e., the sum of all payments) for the loan will be $125,000. Learn more here.
g) Origination costs
MCA origination costs vary greatly. They are charged as a percentage of the total loan. For example, the origination costs could be 1.5% or 2.5%. In general, these costs depend on what your broker wants to charge you.
Most factoring lines don’t have origination costs. The market is so competitive that those fees have been eliminated, for the most part. The exception to this rule is large or complex deals.
Know the risks!
Every financing product has risks. The key to using financing effectively lies in knowing and managing these risks.
a) Merchant cash advances
The greatest risk with business cash advances is running out of funds. This happens in any of these cases:
- The borrower asked for less money than they actually needed
- The business was not able to absorb financing costs
- The business does not have regular cash flow
Most borrowers try to solve this problem by getting a second cash advance loan. But instead of using the funds to pay the first one, they run both loans at the same time. This approach is called “stacking.”
The problem with stacking is that the situation soon becomes impossible to manage. This scenario causes the borrower to seek a third loan and repeat the process.
Ultimately, stacking cash advances leads to a financial spiral that often results in failure. This situation is often referred to as a “debt trap.” This problem, unfortunately, is common. Avoid stacking cash advance loans at all costs.
b) Invoice factoring
The main risk of factoring is that a client doesn’t pay a factored invoice. How this situation is handled depends on the type of factoring you are using.
If you use conventional factoring, you are responsible for all non-payments. You have to return the advanced funds plus any fees to the factoring company.
If you use a non-recourse factoring program, you are responsible only for some non-payments. You are usually not liable if your client does not pay due to insolvency/bankruptcy. However, you are still responsible for non-payments if the client is not satisfied with your work/product.
The risk of non-payment is usually very small because factoring companies run detailed credit reports on your client before advancing against an invoice.
Need invoice factoring?
We are a leading provider of invoice factoring and can offer competitive quotes. For a quote, fill out this form or call us toll-free at (877) 300 3258.