In this article, we compare invoice factoring and conventional business loans. We discuss:
- What is a term loan?
- What is invoice factoring?
- What do you want to accomplish?
- Product comparison (7 criteria).
- Things to keep in mind.
- Which product is right for you?
1. What is a term loan?
A term loan (i.e., small business loan) is a form of financing that allows you to borrow a specific amount of money. It’s a common product that provides the funds as a lump sum. Loans are repaid in monthly installments with payments amortized over one to three years.
2. What is invoice factoring?
Factoring is a tool that finances slow-paying invoices (accounts receivable). Instead of waiting 30 to 90 days to get paid by customers, you get an immediate advance from the factoring company. The transaction settles when your customer pays in full. For more information, read “What is Factoring?” and “How Does Invoice Factoring Work?”
3. What goal are you trying to achieve?
Factoring and business loans are very different products and solve very different problems. Furthermore, they have different structures and pricing models. Factoring is somewhat similar to a line of credit and works best for improving cash flow. Use invoice factoring to pay for ongoing expenses related to sales and operations such as payroll, maintenance, inventory, etc.
In principle, you can use a term loan to handle a short-term cash flow problem. However, it is not the best option. Term loans work best for three things:
- Acquiring assets (e.g., machinery)
- Managing one-time (short-term) cash shortfalls
- Handling the costs of a large, one-off project.
4. Product comparison
In this section, we compare business loans against accounts receivable factoring. We compare both products using six criteria.
a) Ease of getting
Getting a factoring line is relatively easy. The solution has few qualification requirements. Your clients must have good business credit, and your company must have good invoicing practices. Aside from that, your invoices cannot be encumbered by liens, and the company owners must have good character.
Qualifying for a business loan is more complicated. First, your sales must exceed a certain value. Additionally, your company must show a few years of profitable operations. Lastly, the company must have sufficient assets and cash flow to justify the loan. Generally, business loans require that you provide substantial documentation, including:
- Balance sheet
- Income statement
- Payable and receivables aging
- Asset valuations
- Personal financial statement
- Tax returns
b) Speed of funding
Most factoring lines can be set up and provide their first funding quickly, in about five (5) business days. Subsequent invoices can be funded in one business day. Getting funds from a term loan can take a few weeks to a couple of months, depending on the lender, the loan’s size, and the transaction’s complexity.
c) Cost of funds
It is difficult to compare costs because term loans and factoring lines use different pricing structures. However, most term loans are considered cheaper than factoring lines of comparable size.
The average APR of a term loan can be as high as 15%. The cost decreases for larger and higher-quality transactions. Factoring transactions have a short duration, usually 30 to 60 days. The cost per 30 days ranges from 1.15% to 3.5% depending on the transaction details. Learn more about the typical factoring rates.
In principle, you can use a business loan for any approved company purpose. However, just because you can use a loan for any purpose doesn’t mean you should.
In general, loans are best used to buy machinery, equipment, or real estate. These asset purchases match the structure and intent of a loan. The lender provides the funds to buy the asset immediately, which you then repay over time through monthly payments. Loans can also be useful for special projects and improvements.
Loans can technically be used to pay for ongoing business expenses. However, they are usually not a good choice for this purpose. This is because the amount of funds available to your business from the loan decreases monthly as you repay the lender.
Factoring, on the other hand, is better suited to help pay for ongoing expenses associated with running the business – payroll, inventory, maintenance expenses, etc. Factoring is not a good solution if you are looking to buy machinery or similar assets.
Factoring lines can easily adapt to growth. Getting an increase can be as simple as submitting a new client and a set of invoices for review. Term loans cannot usually be easily increased. Your only option is to get a new loan for a larger amount. However, you can’t have two loans open at the same time. You must use funds from the second loan to pay off the first loan.
f) Availability to new companies
Factoring financing is available to both startups and established companies. Business loans are not usually available to new companies. Companies must show assets and a three-year track record before they can qualify.
g) Restrictive covenants
A covenant is a loan clause that determines certain behaviors of the borrower. It specifies targets and actions that the borrower must comply with. Falling out of covenant could trigger a repayment demand from the lender.
Business loans tend to have comprehensive restrictive covenants, which can include maintaining financial ratios, revenue, and profitability targets. Most factoring programs have minimal covenants. They are usually designed to protect factoring companies from serious events, such as default or fraud.
5. Things to keep in mind
This section covers some general issues business owners should keep in mind if they choose either solution. This section is not comprehensive but describes the most common concerns we have seen when speaking with clients.
a) Business loans
As we mentioned previously, a business loan is not the best solution to handle an ongoing cash flow problem. The main concerns are that you may outgrow the loan sooner than expected, or you could fall out of covenant. In principle, outgrowing a loan sounds positive. It means the company is growing, right? The problem is that getting a loan increase is difficult, especially if the loan is recent. Falling out of covenant is also a concern since many small companies have revenue volatility.
b) Invoice factoring risks
A common concern with factoring lines regards what happens if an invoice is factored but the end customer doesn’t pay. How this situation is managed depends on the type of factoring agreement that you have. In a recourse agreement, you are responsible for any non-payments, regardless of the reason. You must return the advance, plus some fees, to the factoring company.
In a non-recourse factoring agreement, you are not liable for returning funds if the reason for non-payment is client insolvency. To be valid (in most cases), the insolvency must occur within 90 days of when you factored the invoice. If a client does not pay for another reason (e.g., dispute), you are responsible for repaying the factor. While there is always a risk of non-payment, it is very low. Non-payments are rare. Factoring companies do thorough credit reviews of your invoices before funding them. This diligence minimizes the risk.
6. Which product is right for you?
The choice of product depends on what problem you are trying to solve and your company’s needs. If your company does not have a finance team, consider working with a CPA to help determine the right solution for your business.
Generally, a business loan is the better option for buying capital goods. Business loans can be used for cash flow problems but aren’t ideal. Invoice factoring is a better option for handling ongoing cash flow problems, especially if the business is unpredictable or growing quickly.
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