In this article, we compare invoice factoring and conventional business loans. We discuss:
- What is a term loan?
- What is invoice factoring?
- Product comparison (6 criteria).
- Product risks.
What is a term loan?
A small business loan is a form of financing that allows you to borrow a specified amount of money. It provides the funds as a lump sum. Loans are repaid in monthly installments. Terms loans usually are amortized over 1 to 3 years.
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 factoring. The transaction settles when your customer pays in full. For more information, read “What is factoring?” or get a product summary.
What goal are you trying to achieve?
Few financial products work well in all scenarios. Most products work well only for specific uses. Thus, choose a financing product that supports your objective.
Factoring and business loans are very different products and solve very different problems. Furthermore, they have different structures and pricing models. Consequently, making an accurate side-by-side comparison is difficult.
However, follow this rule of thumb. Factoring works best for improving cash flow. Use it to pay for ongoing expenses related to sales and operations such as payroll, maintenance, inventory, etc.
Term loans, on the other hand, 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.
In this section, we compare business loans against accounts receivable factoring. We compare both products using six criteria.
1. Ease of getting
Getting a factoring line is relatively easy. The solution has few qualification requirements. Your company must have creditworthy clients and 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 difficult. 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
2. Speed of funding
Most factoring lines can be set up and provide their first funding 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 size of the loan, and the complexity of the transaction.
3. Cost of funds
It is difficult to compare costs because term loans and factoring lines are priced differently. However, most terms 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.
In principle, you can use a business loan for any company purpose – which makes this loan very useful. However, just because you can use a loan for any purpose doesn’t mean that 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 of the amount of funds available to your business from the loan decreases every month 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 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 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.
6. 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.
Getting business financing always carries a level of risk. In this section, we explore some of the risks associated with these products.
Business loan risks
The main risk of a business loan is that you will outgrow it. This happens if you need more money before the term of the loan is over.
Some institutions may increase your loan, but this is rare. In most cases, you will need to secure a larger loan to close the first one, as explained in point #5.
Invoice factoring risks
The major risk in a factoring transaction is if a client does not pay their invoice. 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 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 a 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 any other 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.
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.