As a business owner, you want to use the right financing tool to address your needs. This article compares two common financing tools: business cash advances and invoice factoring. It explains how each option works and helps you determine whether either solution is right for your business. In this article, we cover:
- What is a business cash advance?
- What is factoring?
- What problem are you trying to solve?
- Product comparison (7 criteria)
- Product risks
1. What is a business cash advance?
A business cash advance is a product that provides funding against your future sales. It is also known as a merchant cash advance (MCA). The advance is for a fixed amount and usually for a short term (months). The funds can be used for any business purpose.
The advance is repaid through a daily or weekly debit from your bank account. Learn more about business cash advances and how they work.
2. What is factoring?
Factoring is a tool that provides funding against 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 before the invoices are due.
You can use those funds for any business expense. Most companies use factoring to pay recurring expenses such as payroll, operating costs, and suppliers.
Factoring is structured as an ongoing solution designed to improve cash flow. It can finance all or some of your invoices, depending on your needs. Factoring lines can grow with your sales.
Learn more about invoice factoring.
3. What problem are you trying to solve?
The first thing you should do before looking for financing is determine what financial problem you are trying to solve. The financing solution you choose should match that need. Otherwise, you may end up with more problems.
Factoring is a great solution if you are dealing with ongoing costs. As mentioned earlier, you can use factoring to cover payroll. You can also use it to pay suppliers, rent, and other operating expenses.
However, factoring is not the best solution to cover large, one-time expenses such as the purchase of machinery or equipment. A specialized term loan product is usually a better option.
4. Business cash advance vs. factoring
In this section, we compare merchant cash advances and factoring against the following seven criteria:
a) Effectiveness
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 suited to covering one-time company expenses or projects such as purchasing machinery, equipment, etc. These products can also be used to finance large inventory purchases or 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 the initial funding. Subsequent fundings are usually done in one business day. By comparison, 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 repay your existing advance and meet your new requirements. When this process is not managed properly, it can lead to serious financial problems. This issue is discussed in the “Product risks” section.
e) Available to startups
Invoice factoring can be used by newly established companies. Business cash advances require 3 to 6 months of operating history (varies by provider).
f) Cost of funds
Comparing the cost of factoring to the cost of a cash advance can be difficult because both products have different structures. In general, the cost of factoring ranges from 1.25% to 3.5% for every 30 days an invoice remains open.
The costs of an MCA are based on applying a multiplier known as the ‘factor rate’ to the advance amount. The factor rate can range from 1.15 to 1.40 (115% to 140%). For example, assume a $100,000 advance with a 1.25 (125%) multiplier. The total repayment amount (i.e., the sum of all payments) for the advance will be $125,000.
g) Origination costs
MCA origination costs can vary considerably. They are charged as a percentage of the advance amount, such as 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.
5. Product risks
Every financing product has risks. The key to using financing effectively is understanding 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 requests less money than the business actually needs
- The business cannot absorb the cost of financing
- The business does not have consistent cash flow
Most borrowers try to solve these problems by getting a second cash advance. But instead of using the new advance to repay the first one, they keep both advances open. 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.” Unfortunately, this problem is common.
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 program you use.
If you use conventional factoring, you are responsible for all non-payments. You have to repay 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 or 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 often reduced because factoring companies run detailed credit reports on your client before advancing against an invoice.
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Marco Terry is the Managing Director of Commercial Capital LLC and has over two decades of experience in asset-based finance. He has worked with small and mid-sized companies across the United States, Canada, and Australia. Marco holds a Master of Science in Finance.