Why Factoring Is Better Than a Bank Line of Credit?

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:

• Is this a business to business (B2B) or business to government (B2G) invoice for a product or service that has been delivered or completed?
• Is the account debtor or customer able to pay the invoice?
• Does the business actually have an accounts receivable?

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:

1. A percentage of the invoice value
2. How long the invoice remains unpaid
3. There can be wire and ACH fees
4. 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 just