Cash flow problems are a common challenge faced by businesses of all sizes. When customers take a long time to pay, working capital remains tied to the pending invoice. This leads to financial woes, such as payroll issues, delayed supplier payments, and even turning away new contracts due to the lack of funding.
In these situations, business owners can choose between two options: take another business loan or sell their invoices through factoring.
In this post, we’ll discuss how factoring and business loans differ and how the best factoring services might be the solution your company needs.
How invoice factoring works
Invoice factoring involves selling your pending accounts receivable to a third-party factor. Upon selling eligible invoices, you’ll receive a cash advance of up to 97% of their total value.
Since you’re selling the invoice to the factor, you’re also transferring collections to their team. So once you receive the cash advance, the factoring company will be the one to collect payment from your customers.
After collecting the invoice, the factor will send you the remaining balance, minus a small factoring fee.
Take note that factoring is NOT a loan. Instead, you’re selling your pending invoices, and it doesn’t incur any interest or monthly payments.
Pros
- Businesses can qualify with factoring even with a less-than-ideal credit score
- Startups and small businesses can easily qualify for factoring
- You’ll get funding for your factored invoice in as little as 24 hours.
- You no longer have to chase payments since the factor takes over collections.
Cons
- Your customer will be notified that their invoices have been factored.
- B2C invoices are not usually eligible for factoring
- You don’t have control over the collections process.
How business loans work
Traditional business loans work by borrowing money from a bank or lender with interest. Once your loan application is approved, you’ll receive a lump sum upfront, which you have to repay over time. Typically, you’ll have to service the debt through fixed monthly payments.
Unlike factoring, where you sell your invoices, traditional loans will add to your balance sheet. Also, business loan approvals could take weeks with no guarantee of favorable results.
Still, business loans aren’t a total bane. It’s ideal for large business expenses, such as acquiring new equipment, opening new branches, and more. Also, traditional loans don’t impact customer relationships since the transaction is between you and the lender only.
Pros
- Ideal for large expenses in your business
- Business loans can help build credit when paid on time.
- There’s no customer involvement in the process.
- Interest payments on loans are often tax-deductible
Cons
- The approval process can be lengthy and strict.
- Business loans require a good credit score
- You have to service the debt monthly even after you’re done spending the money.
Key differences between factoring and business loans
While both factoring and business loans can supplement your cash flow, they come with stark differences:
- Source of funds. Business loans are funded by banks, credit unions, and lenders. Meanwhile, factoring is simply selling your invoices for cold cash.
- Approval process. Factoring has a faster and more straightforward approval process compared to business loans. It’s ideal for companies that want to inject cash into their operations quickly.
- Overall cost. Business loans have varying interest rates, not to mention that they also come with overhead costs. Meanwhile, factoring charges are one-time fees that can either be fixed or variable.
- Risk level. With business loans, you’re responsible for servicing the debt regardless of your current cash flow. Meanwhile, you can opt for non-recourse factoring where the risk of non-payment is partially transferred to the factor.
Which one is best for your business?
Both factoring and traditional loans are good sources of funding when used properly. However, if your cash flow problems are mainly due to unpaid customer invoices, you should consider factoring as a solution.
Meanwhile, if you need larger funding to expand your working capital, business loans could be the ideal option.
Overall, always assess which financial solutions work best for your business in terms of long-term costs, risk level, convenience, and impact on your balance sheet.
