At one point or another, every business finds they are faced with a cash flow problem. It simply means that you are spending more money than you are bringing in at that time. With a newer business, you can expect cash flow problems because you haven’t built up the reserves you need to cover the receivables that are owed to you.
Without having a solution in place in the event that your cash flow becomes a problem, you may not be able to afford the assets you need to run your business effectively. This could be equipment, software, or even staff. Poor cash flow management could even end up putting you out of business.
In some cases, we have seen companies wait until their cash flow is such a problem that they are forced to look at loans that have higher interest rates, which ends up costing them much more than if they had been proactive and sourced a desirable cash flow solution. This is why keeping a close eye on your cash flow is crucial to the success of your business.
In fact, Jack Welch, former Chairman and CEO of General Electric and current Executive Chairman at The Jack Welch Management Institute stated:
“If I had to run a company on three measures, those measures would be customer satisfaction, employee satisfaction, and cash flow.”
Even if you don’t have regular cash flow problems or are experiencing problems right now, most businesses eventually experience some type of pressure on their cash flow. It may be a downturn in the economy, a quickly growing payroll, a slowing of your industry sector, a seasonal sales issue, or even an unexpected tax liability. The majority of these factors are beyond your control and you need to be prepared for unexpected fluctuations in your cash flow.
No matter the cause, when time is of the essence you normally have two choices: A bank loan (or “line of credit”), or a bank loan alternative like accounts receivable factoring. In this article, we talk about the main differences between a bank line of credit and a factoring line of credit, and we explain why the latter may be a better option for you and your business.Here are the differences between these lines of credit and why factoring may be a better option:
What Is A Factoring Line Of Credit?
A factoring line of credit is a line of credit facility with an accounts receivable factoring company that is based on outstanding invoices that will increase and decrease with your outstanding accounts receivable.
If you have an arrangement with a factoring company where they will advance 90% on outstanding accounts receivable, then your credit line would typically be 90% of your eligible outstanding accounts receivable or invoices. You use this line of credit or factoring line by requesting to factor invoices that you have outstanding, and then the factoring company will advance the amount of funds you need in a matter of hours.
How Do You Qualify For A Factoring Line Of Credit?
Qualifying for a factoring line of credit is a much simpler process than qualifying for a line of credit with a bank. You fill out an application form that gives the factoring company insight into a few key facts they need to know before choosing to approve or deny your application.
The key things that factoring companies look at when considering an application includes the following:
Factoring companies main concerns are not how many years a company has been in business or what is the business owner’s credit score. The main concern is that the invoice factoring company is buying invoices that will get paid. For this reason, factoring has proven in its’ different forms over the centuries, that it is a very valuable tool for a growing business that needs a finance partner to improve cash flow.
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Reasons Businesses Do Not Qualify
Just like with bank lines of credit, there are some cases where businesses are not approved for factoring lines of credit. As a result, businesses need to explore other forms of financing for their business.
Some of the common reasons applications will be rejected include:
1. Pre-Billed or Progress Billed Invoices:
A factoring company is knowingly taking on the credit risk or the risk of the customer being able to pay the invoice or not. As a result, the company does not want to take on the risk of production. Since the factoring company cannot take on a project their client is working on and complete it for them, the factoring company will want to make sure that the job is done before purchasing an invoice. If the invoice is billed before the service is complete, a factoring company would not be able to purchase or fund against it. In the same way, if an invoice is submitted for a service that is only partially completed then the same problem would arise.
2. Businesses That Solely Invoice Consumers
As a factoring company is purchasing invoices primarily based on the credit-worthiness of a business customer, they are unable to purchase invoices that are to an individual. Factoring companies are a good fit for companies that have business-to-business (B2B) or business-to- government (B2G) receivables.
3. Businesses Without Accounts Receivable
There are many businesses that simply do not have accounts receivable. Many software companies require payment before any service is rendered and many other types of businesses require up-front payment before starting any work. These businesses would not be a good fit for a factoring company.
What Does A Factoring Line Of Credit Cost?
There are a number of different factors that will determine factoring costs for your business. One is how long it takes for your customers to pay. But, typically factoring costs starts at less than 1% and can go up to 4% or so if your clients take a long time to pay. Some examples of different fees that you may come across include:
- A percentage of the invoice value
- How long the invoice remains unpaid
- There can be wire and ACH fees
- Administrative fees
When you’re thinking about opening up a factoring line of credit - like anything else - make sure you read your contract thoroughly and familiarize yourself with all the rates and fees. You will avoid any unwanted surprises down the line.
Bank Lines of Credit: Pros and Cons
Let’s now turn our attention to bank lines of credit. They can be a quick cash flow solution if they are already set up. Here’s how they work:
The bank approves you for a certain amount, or line of credit, but you don’t draw on that line or amount unless you need it. So, if you have a $100,000 line of credit and you need $50,000 for cash flow one month, you can draw on the $50,000 and be charged interest on that amount until it is fully paid back. Sometimes, but not always, the bank charges you annual maintenance fees or a fee based on the entire line of credit even if you don’t use it all. Again, make sure you are reading all of the documentation to ensure you are comfortable with the fees. If you do come across a situation where you are going to be charged fees based on the entire line of credit, even if you don’t use it, we would suggest looking at how much of the line of credit you will use on average to see if you can justify these kinds of charges. If you don’t expect to use a large sum of the line of credit without paying it back fairly quickly, it would be wise to look at other options and avoid those hefty maintenance costs.
A line of credit does have some strong points. First, you can get the money you need quickly, assuming you set a line of credit up beforehand. Typically, the interest rates and fees are reasonable if you have been in business for a long time and have a strong credit history.
As with any loan from the bank, the banks can require burdensome paperwork and invasive business and personal financial disclosures to obtain credit lines. This requires a great deal of time that most business owners don’t have. Many business owners do not want to deal with this hassle. Plus, an approval can be hard to come by, especially if the economy is struggling, or your credit history is not perfect. You may even be approved for some credit but often it is not the amount a business owner really needs to successfully run their business. In addition, if you haven’t been in business for very long, the bank may flag you as too much of a risk and decline your application for a line of credit with them.
In addition, the banks can change their terms. The interest rates may go up, the fees may increase, or the line of credit can even be terminated at the bank’s discretion. If you carry a balance, just like with a credit card, the interest charges can add up over time. Not to mention, the sustained debt load can weigh on your future cash flow and your current credit standing.
Just imagine having a line of credit in place to help with your business cash flow and then all of a sudden, they let you know they are terminating it. You now have to take the time to pay off the balance - and that’s even if you have enough cash flow to do that right away - go out and find another line of credit option, and go through the application process again. That’s valuable time away from your business.
A Better Alternative: Accounts Receivable Factoring
Invoice factoring is similar to a bank line of credit in one respect; you can access cash fast, but unlike a bank line you do not have to go through an overly cumbersome approval process - waiting weeks or months without hearing back at all as to whether or not you may be obtaining this much needed capital. Factoring companies are getting better than ever and are providing the needed capital sometimes in as little as 3-7 days. Although there is an application for this type of financing, many factoring companies have made it very easy, and don't scrutinize your business credit. The factor bases their financial arrangement primarily on your outstanding invoices and the creditworthiness of your clients.
You normally receive about 80% to 95% of the face value of your invoices upfront, and then receive the remainder, (less the factor’s charges), once the payments are collected. You, or rather your invoices, determine the amount of cash you receive, not the bank. So if you need $100,000, you can factor enough invoices to get that cash. If you only need $20,000 you can factor a smaller amount of invoices. In addition, you don’t have to collect on the invoices, the factoring company takes over the responsibility. Also, you do not carry debt every month. You can choose to factor more invoices but you do not have an ongoing loan balance like you do with a bank line. Therefore, your credit report looks better.
Here’s a quick overview of what the steps would look like for your Factoring Line Of Credit:
Step 1: Invoice submission
You submit your invoices to the factoring company along with any backup you may have to substantiate the invoice. Once the factoring company is able to verify that the invoice is good, they typically advance 80 to 95 percent of the amount of the factored invoices the same or next day. For example, if you sell $100,000 worth of accounts receivables and get a 90 percent advance, you will receive $90,000.
Step 2: Accrued Reserve
The accounts receivable factoring company holds the remaining 10-percent or $10,000 as security until the payment of the invoice or invoices have been received.
Step 3: Payment Collection
The factoring company collects payment over the next 30 to 90 day period depending on your customer’s payment terms.
Step 4: Final Payment to Seller (You)
Once the payment has been received, the factor pays you (the seller of the invoices), the remaining ten percent, less the factoring fee, which typically runs one-percent to three-percent of the total invoice value.
So, let us answer the original question, which is: Why is a factoring line of credit better than a bank line of credit?
A Factoring Line of Credit provides you with the same quick cash flow as a bank line of credit, but you don’t have to go through the hassle of an intrusive approval process, worry about the economy or lending environment, wait weeks or months to hear whether you can obtain the much needed capital, deal with unexpected rate or fee changes, keep debt on your books month after month, or worry about having the source of extra cash flow being terminated.
A Factoring Line of Credit gives you the capital much quicker, it does not discriminate based on the age of your business or your credit score, the rates and fees do not fluctuate - which avoids any unwanted surprises - and the factoring company handles the gathering of funds from the invoices you submit. The ease of use and application, and its stability is what makes it a much better option for your business when compared to a bank line of credit.