Payroll financing has been gaining traction as an effective way to provide funding to companies that need working capital to pay their employees. Companies with large payrolls often experience cash flow problems because of slow-paying clients. When this happens, the company must pay employees out of its own cash reserves. If the company is growing quickly, cash reserves can be depleted, thereby preventing growth.
Traditionally, payroll financing is used by consulting and staffing companies. However, this solution can be used by companies in most industries, as long as they need funds to meet payroll and sell products/services to commercial clients. Payroll financing is also available to small businesses and startups, as long as they meet the funding requirements.
In this article, we discuss the pros and cons of payroll financing. Note that this article emphasizes payroll financing as offered through an invoice factoring plan (learn more about factoring).
If you are not familiar with payroll financing, read “What is Payroll Financing? How Does it Work?”
A payroll financing solution offers numerous advantages for your company, especially if the company is growing quickly. The most important advantages include:
1. Enables you to grow your business
The most important advantage of using a payroll financing solution is that it helps you grow your business. Commercial clients typically pay their invoices slowly, in 30 to 60 days. This delay can hurt your cash flow and may prevent you from adding staff to handle business growth. Payroll financing enables you to add the staff you need to fulfill new client orders and grow.
2. Some types of payroll financing are easy to get
Some types of payroll financing, such as factoring, are easy to get. Usually, the most important requirement to qualify for factoring is to work with creditworthy commercial/government clients.
Factoring companies don’t require the traditional underwriting that banks go through. This advantage is important for small and growing businesses that can’t meet bank lending requirements. By the way, if you are looking for other solutions, read “Seven Payroll Financing Alternatives”.
3. Most lines are flexible
Lines offered through a factoring solution are flexible and can grow with your business. This key advantage can be helpful while your business is getting new orders and needs additional staff. The line is adaptive and grows as long as your clients have good commercial credit and your company continues to meet the funding requirements.
4. Can be transitioned to conventional financing
Another advantage is that factoring can be used as a stepping stone to conventional financing solutions, such as business lines of credit. Companies often use factoring for a couple of years and move to other solutions once they have built a track record.
Although lines of credit tend to have more restrictions, they are usually more cost-effective. As a result, lines of credit are a good option for businesses that are maturing.
5. Allows you to offer net-30 terms to clients
Perhaps one of the most significant challenges for businesses is that most commercial clients pay in 30 to 60 days. However, businesses have to pay employees every one to two weeks. Unless you have a cash reserve, this model does not sustain growth. Your reserve eventually run outs. This problem is especially difficult for staffing and consulting companies.
Payroll financing helps you bridge the gap between rendering a service and getting paid. This solution allows you to offer competitive terms to your clients and provides a financial platform for adding clients.
6. Can be obtained quickly
Some payroll funding solutions can be obtained quickly. For example, a factoring line can usually be obtained in a week or so. Obviously, the time it takes to deploy a line varies based on clients’ individual circumstances.
7. Factoring does not incur debt
Lastly, factoring transactions are usually structured as the sale of your receivables, rather than as a loan against them. This structure can be important for larger companies who may look for conventional funding later on.
Payroll financing solutions are not perfect. The two most important disadvantages are:
1. Costs more thank bank lines of credit
Payroll financing, especially factoring, usually costs more than conventional bank financing. Consequently, payroll financing is best used by companies that have higher margins or companies that get paid quickly.
Factoring costs are determined through a combination of volume and the payment speed of your clients. It works best if your company has a minimum gross margin of 15%; however, higher margins are better. If your clients pay invoices slowly (i.e., 60 days or longer), consider financing only those invoices that have higher gross margins.
2. Some lines are not transparent to your clients
Lastly, factoring lines are not always transparent to your clients. However, factoring companies always work with you to determine the right way to deploy the solution and minimize client issues.
Payroll financing can be an ideal solution for companies that are growing quickly and need funding to cover staffing costs. However, this solution works best if your:
- Commercial clients have good credit
- Clients pay on 30- to 60-day terms
- Margins are at least 15%
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