Every business needs capital to start and a steady influx of cash to keep running. If you have an established client base and regular positive cash flow, you’ll achieve self-sustainability, and your business can keep running indefinitely. But if you’re struggling to start, if your revenue generation suffers seasonal disruptions, or if your customers aren’t paying you on time, you’ll need a funding solution to keep operating.
In these tough financial situations, most business owners immediately turn to bank loans for financing options. While these can be valuable and relatively inexpensive ways to get the cash your business needs (especially short-term), they’re not always the best financing option. Small and midsize business (SMBs) have great difficulty meeting loan qualification requirements, and restrictive covenants that govern the loan and can impede business growth.
Instead, it may be better to tap into the power of factoring. But what’s the difference between invoice factoring and bank loans? And is one always the right decision?
Invoice Factoring vs. Bank Loans
You likely already have some idea of how bank loans work. In a traditional environment, a company or individual will borrow money from a lending institution and pledge collateral to secure the loan. Over time, the company or individual will work to pay this loan back with interest. Depending on the loan structure, payments may be due monthly, starting immediately, or the full principal and interest will be due at some specified date in the future.
Invoice factoring, by contrast, uses your existing invoices as collateral. If you have outstanding invoices due from your customers, you can sell those invoices to a third party for a discount. You’ll get an immediate injection of cash, and your customers will pay the third party directly for the invoices sold.
Advantages of Invoice Factoring
There are several advantages to invoice factoring, especially when compared to bank loans:
- No incursion of debt or compound interest. Invoice factoring isn’t a loan. Instead, you’ll be selling your invoices to a third party for immediate cash. Accordingly, your business won’t be burdened by covenants or compounding interest and there are no regular payments due. Instead you’ll be selling your invoices for a discount – in other words, you’ll be collecting money upfront (within 24 hours) for a nominal fee. You won’t have restrictive covenants or interest hanging over your head.
- Quick and simple approval. Depending on the lending institution and the loan terms, it can take weeks, or even months, to get approved for even a modest-sized commercial business loan. By contrast, invoice factoring usually involves a much faster, more streamlined approval process. If your company has creditworthy customers, qualification is generally approved within a few days.
- Fast funding. In line with this, you’ll likely be able to capitalize on fast funding. Most invoice factoring institutions make it a point to ensure their clients start funding within a day or two of approval. Once an account is set up, submitting invoices is easy, and funds are transferred within hours, not days or weeks.
- Leverage your customers’ credit. Banks want to protect themselves financially, so it’s understandable that they only lend to businesses and individuals with a high credit score. But with invoice factoring, your credit isn’t a problem; your customers are the ones paying the money back, so funding is contingent on their credit. If your customers are creditworthy your business will qualify for invoice factoring. This is ideal for startups, companies in transition or growing, and businesses with poor credit.
- No strict upper limit. With conventional bank loans and lines of credit, there’s a maximum amount of capital you can tap into. But with invoice factoring, you can keep getting more money for as long as you have invoices to sell from good credit customers.
Advantages of Bank Loans
While there are many viable alternatives to bank loans these days, bank loans remain a cost-effective financial tool for businesses with good credit to wield:
- Lack of dependence on invoices. The biggest weakness of invoice factoring is that it relies entirely on your company’s current accounts receivable invoices. If you don’t have a reliable customer base, or if you need an amount of money that exceeds the total of all your outstanding invoices, bank financing may be your only option.
- A multitude of options. There’s no single description of a “bank loan,” since banks can lend you money in a variety of ways. If you have a solid credit history, shop around to different lending institutions. If you’re willing to negotiate a bit, you can often find a great interest rate, impressive terms, and an overall loan structure that serves your needs exactly. You’re not locked into only one type of business loan.
- Flexible repayment. With invoice factoring, you won’t be repaying a loan at all, you’ll simply pay a small fee on each invoice for advanced funds. But in the realm of conventional loans, you’ll typically have a payment schedule to comply with. Depending on the type of loan and the institution you are borrowing from, you may have access to flexible repayment plans. For example, with a floating line of credit, you can often make payments gradually as you see fit.
Invoice Factoring vs. Bank Loans: Which is the clear winner?
So is invoice factoring better than bank loans? It depends on the stage of development your company is in. For stable companies with good credit, a conventional bank line of credit or a business loan are good options for providing a cost-effective funding solution. However, a majority of SMBs are startups, have a cash flow gap to fill or are in some form of growth mode. For these companies, invoice factoring provides the ideal working capital solution.
If you have standing invoices that are as-of-yet unpaid, if your company doesn’t have the credit to take out a conventional bank loan, or if you need funding fast, invoice factoring is the clear winner of the head-to-head comparison.