At some point in the life of your business, you will likely need funding. There are several options out there for small businesses. Two of the most common are invoice factoring and business loans. In this blog, we’ll compare the two to help you determine which one is best for you.
Questions to Ask about Business Loan vs. Invoice Factoring
When you are weighing your funding options, there are several questions that you need to consider when trying to decide between a business loan and invoice factoring.
Definition of Business Loan
A business loan is a type of financing that allows you to borrow a specific amount of money, commonly provided as a lump sum. Typically, installments are due monthly and amortized over 1-3 years.
Definition of Invoice Factoring
Factoring is a financing tool that covers slow-paying accounts receivable. You submit your invoices to a factoring company and instead of waiting 30 to 90 days for the customer to pay you- the factoring company advances you the money. Once your customer pays the factoring company, the transaction is settled.
What Are Your Goals?
A business loan and invoice factoring are very different products that are designed to solve very different issues. Plus, the structures and pricing models are different. Invoice factoring is a lot like a line of credit and can improve your cash flow. You should use invoice factoring if you need to pay ongoing expenses such as inventory procurement, maintenance, payroll, etc.
While you can use a business loan to cover a short-term cash flow issue- it’s not the best option. Business loans are best for:
• Managing short-term cash shortfalls
• Acquiring assets
• Handling costs related to a large project
Comparing Business Loan vs. Invoice Factoring
Below, we will compare and contrast these two funding options using six criteria.
How Easy is it to Get?
Invoice factoring is easy to get. There are very few qualification requirements. Your client must have decent business credit and your company must use proper invoice practices. Other than that, there must not be any other liens on the invoices and the owners of the company must have good character.
A business loan, on the other hand, is a bit more complex. First of all, your sales must be at a certain value. You must be able to show a few years of profit. Finally, you must have the assets and cash flow to justify needing the loan. As a general rule, you’ll have to provide the following:
• Balance sheet
• Asset valuations
• Tax returns
• Income statement
• Personal financial statement
• Payable/receivables aging
How Quickly Does Funding Occur?
Most factoring lines can be set up within about 5 business days. Once it has been set up, any future invoices can be funded in about 1 business day. A business loan, on the other hand, can take up to a few weeks to a couple of months, depending on a few factors: the lender, the size of the loan, and the complexity of the transaction.
What Are the Costs of Each?
Comparing the costs of a business loan versus invoice factoring is complicated because they use different pricing structures. Most of the time, loans are cheaper than factoring.
The average APR for a business loan can be up to 15%, which may decrease for larger, high-quality transactions. On the other hand, factoring transactions are typically shorter, typically 30 to 60 days. The rate on a 30-day factor is 1.15 to 3.5%, depending on the details of the transaction.
What Should You Use the Funding For?
Typically, a business loan can be used for any purpose- but that doesn’t mean you should do so. Loans are best for one-time purchases and the asset purchase must match the intent and structure of the loan. The funds are provided for the asset to be purchased immediately and repaid over time through monthly installments. You can use a business loan to cover ongoing expenses, but this isn’t typically the best option.
Factoring is best for ongoing expenses such as payroll, maintenance, inventory, etc- it is not the best solution for assets.
Can Either Be Adapted?
A factoring line can be adapted to your business growth. An increase is as simple as submitting new clients and invoices. A business loan is not as easy to increase. The only option you have is to get a new, larger loan- but you can’t have two loans at once. You would have to use the funds from the second loan to pay off the first.
Which is Available to New Companies?
Whether you are an established company or a startup, you are eligible for invoice factoring. A business loan, on the other hand, is not typically available to new companies. you must be able to show a 3-year track record and assets to qualify for a loan.
Are There Any Restrictive Covenants?
A covenant is a clause that regulates how the borrower behaves. It outlines targets/actions that the borrower must comply with. If the borrower does not follow the covenants fully, the lender may demand immediate payment.
A business loan typically has comprehensive restrictions, which may include maintaining profitability, financial, and revenue targets. There are typically very few covenants involved with factoring programs. If there are covenants, they exist to protect the factoring company from default or fraud from the borrower.
Things to Think About
Below, we’ll outline some of the most common issues that come up with either solution.
A business loan is not the best financing solution to handle ongoing cash flow issues. The primary issue is that you may outgrow the loan sooner than expected or you may not meet the covenant. Outgrowing a loan may not seem like such a bad thing- after all, it’s good when the company grows. However, getting an increase can be difficult- especially if it’s a recent loan.
One of the most common concerns with invoice factoring is what happens when you factor an invoice, but your customer doesn’t pay. The way this is handled will depend on your factoring agreement. If you have a recourse agreement, you must pay non-payments, no matter what the reason is. This means that you will have to pay the advance back, plus fees.
On the other hand, if you have a non-recourse agreement, you will not be liable for the funds if the reason is due to client insolvency. To be valid, the insolvency must occur within 90 days of the invoice being factored in. If the client disputes the charge, you must repay the factor. However, it’s important to note that while there is a risk of non-payment, it rarely happens. The factoring companies take care to thoroughly review your invoices before funding them to minimize the risk.
Which is Best for You?
The option you choose depends on the needs of your company and the issue you’re trying to solve. If you have a finance team, work with a CPA to help you determine the best option. Reach out to Point High Finance to help. We specialize in business funding.
Typically, a business loan is your best option for purchasing capital goods. You can use the funds for cash flow issues, but it’s not the best option. If you have cash flow issues, invoice factoring is the best option- especially if your business is growing quickly or revenue is unpredictable.