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Invoice Factoring vs Merchant Cash Advances: Choosing the Right Funding Solution

By 08.22.22August 30th, 2022No Comments
Invoice Factoring vs Merchant Cash Advances: Choosing the Right Funding Solution

In today’s lending markets, businesses have more funding options than ever. However, for most small and mediums sized businesses (SMBs), bank financing is no longer a choice. Increased regulations, a changing economy, and fewer profits have caused banks to tighten qualification requirements, restricting credit to small and medium-sized businesses.

To meet their capital needs, business owners are now seeking alternative financing solutions that are faster, more reliable, and better aligned with their business goals. Two solutions that have grown in popularity in recent decades are invoice factoring and Merchant Cash Advances (MCAs). But what exactly are their similarities, differences, benefits, and functions? These are the questions we will answer in this article.

The Similarities and Differences of Invoice Factoring and MCAs

Invoice factoring and MCAs are alternative funding options designed for SMBs in all stages of development. They are not loans. They are advanced funds based on company sales. Both funding options are relatively easy to qualify for as they are not subjected to the scrutiny or regulations typically imposed on traditional small business loans. Although similar in this respect, they are, in fact, very different. Invoice factoring advances funds based on current sales, while MCAs advance funds based on future sales. Understanding this difference can help you make better-informed funding decisions.

How Does Invoice Factoring Work?           

Invoice Factoring is a financing option that generates ongoing funding to smooth out cash flow based on existing sales. This financial arrangement is structured on selling outstanding invoice receivables to a factor in exchange for immediate cash.

Once a business delivers products or services and issues an invoice, the invoice is sold to the factoring company. Advanced funds equaling up to 100% of the invoice value are transferred to the business within 24 hours, often much quicker. Once the invoice is paid in full by the business’s customer, the factoring company transfers the remaining balance to complete the transaction. A small fee is deducted during the process as the cost of financing.

Who is Invoice Factoring Best Suited For?

Invoice factoring eliminates the waiting time for your customers to make payments. Payment delays can result in cash flow shortfalls – costs have already been incurred in delivering the products or services, but the revenue is yet to be realized. Invoice factoring fills the cash flow gap and provides immediate access to working capital. It is best used by businesses that have slow-paying customers with good credit.

Following are the Benefits of Using Invoice Factoring:

  • Higher approval rating: Unlike MCAs and traditional loans, invoice factoring does not rely on projections, credit scores, or revenue. Instead, it depends on the availability of unpaid invoices and the credit strength of the business’s customers. If the business generates receivables from creditworthy customers, the business is likely to qualify for invoice factoring.
  • Immediate access to capital: Invoice factoring gives a business access to capital within 24 hours of submitting invoices for financing. Funds are transferred directly into the business’s account for immediate use.
  • Reliable cash flow: Maintaining business stability is more manageable with reliable cash flow. Growth is more attainable with reliable cash flow. The more invoices a business generates from creditworthy customers, the more funds become available. Invoice factoring is the ideal funding solution for startups, companies that struggle to smooth out their cash flow, and growing businesses.
  • Efficient collections outsourcing: Because factoring companies buy invoices, they also take on the responsibility of collections. A team of accounts receivable professionals improves days sales outstanding and maintains healthy customer relations free of charge to the business. Under this arrangement, businesses are relieved of the time, resources, and cost of chasing customers for payment.

There are many advantages of invoice factoring, but a business needs to be aware of the drawbacks of any financing arrangement.

The Disadvantages of Using Invoice Factoring Include:

  • Client reliability: Before issuing capital, the invoice factoring company vets the business’s customer base to see how reliable their repayment histories are. If some of the business’s customers have a long record of late or delinquent payments, any invoices issued to them may be denied financing.
  • Chargebacks: The elemental invoice factoring arrangement is recourse factoring. Under this arrangement, any invoice financed but not paid by the business’s customer within the recourse period will be charged back to the business. However, chargebacks can be minimized by paying a slightly higher fee for the most popular solution—non-recourse factoring.

How Does an MCA Work?

Unlike invoice factoring, which provides on-going funding, MCAs deliver a one-time lump sum advance to a business that needs the money immediately. The advance is based on projected future sales and can be used for whatever purpose the business chooses.

There are two main ways in which MCAs can be repaid:

  • Percentage of Future sales: In this first repayment option, an agreed-upon percentage of the business’s credit and debit card receipts are withheld each day to pay back the MCA. This percentage referred to as the “hold back,” is taken directly from the credit or debit card processor that clears and settles payments.
  • Fixed Payments: The second option is to repay the advance daily or weekly with fixed payments taken directly from the business’s bank account. The business’s daily cash flow provides the means to meet this financial obligation.

Regardless of the method, repayment continues until the advance is paid in full.

So How do MCA Providers Make Money?

MCAs charge a factor rate on their advances. The factor rate is a multiplier, typically ranging between 1.1 and 1.5, applied to your initial loan amount to determine the repayment amount. The factor rate is determined by the MCA provider’s assessment of the business’s industry, the amount of time it’s been in business, and projected profits. Additional fees are also applied as part of the overall cost. The cost of financing for MCAs is considered to be high. Repayment of the initial balance, plus the factor rate and additional fees, can be much higher than the cost burden on credit card balances.

Who is an MCA Best Suited For?

MCAs are typically used as small, quick financing arrangements that can be repaid in a short amount of time. It is designed for businesses with regular cash flow but lacks the credit strength to qualify for bank financing. MCAs should be used when a business faces financial constraints and requires an urgent cash injection upfront.

The benefits of using MCAs include:

  • Good credit is not required: One of the main benefits of MCAs is that qualification does not need good credit since MCAs rely on the business’s projected cash flow.
  • Repayment flexibility: Another advantage of MCAs is that payments do not have to be fixed. Usually, payments are taken as a percentage of sales, allowing the flexibility to align payments with future sales.
  • Speed of funding: The application process does not require extensive documents or financials. The main qualifier that MCA companies look at is the business’s daily/weekly payment processing statements. With good cash flow, a business can qualify quickly and receive funding in as little as a week, sometimes quicker.

As with every lending type, MCAs also have drawbacks to be aware of.

The disadvantages of using MCAs include:

  • Higher costs: Typically, MCAs are more expensive than other financing options, mainly due to the uncertainty of a business’s future revenue and the resulting risk undertaken by the lender.
  • Extra Fees: Although it differs from provider to provider, any business owner taking on an MCA should expect additional fees. These fees can range from administration fees, processing fees, and origination fees, all of which will be debited from your accounts soon after the contract is finalized. The costs can add up quickly, amounting to a sizable portion of your overall loan.
  • Early pay penalty: If, during the MCA period, a business’s revenues increase significantly and you’d prefer to accelerate repayment, you should be aware that the MCA’s effective APR increases. In some cases, there is no benefit to paying the MCA sooner.
  • Debt cycle potential: Finally, while applying and getting an MCA is straightforward, many MCA borrowers need a new advance soon after finishing the first round, mainly due to the facility’s high cost and burden on the business. As a result, MCA’s can potentially place the borrower in an undesirable and costly debt cycle.

Conclusion

Not all financing options are viable solutions for every business. Both invoice factoring and MCAs are easy to acquire. These simple-to-manage funding solutions bring fast financial relief for undercapitalized enterprises. Yet, while both solutions deliver the same benefit of quick access to capital, the financial implications of using these two financing options can be dramatically different.

Invoice factoring is an efficient financing strategy to stabilize cash flow and fuel growth. It is a cost-effective funding solution for businesses that generate invoice receivables from creditworthy customers. This financial strategy strengthens cash flow without relying on the uncertainty of future business.

MCAs are best suited for businesses that require urgent access to capital in a single amount. Businesses that bill frequently and accept credit/debit payments are ideal candidates for this type of financing. Repayment is given via a percentage of future sales or regular daily or weekly payments. Both repayment options can place additional stress on future cash flow.

Finally, when most buyers compare the cost of financing, they find that invoice factoring costs substantially less than MCA. The additional benefits of cost-free accounts receivable management, credit risk management, and industry expertise associated with invoice factoring further positions it as the preferred funding option for many small and medium-sized commercial businesses conducting B2B business.

About eCapital

Since 2006, eCapital has been a trusted financial partner for thousands of small to mid-size companies in all stages of development. Our customer base continues to grow as our reputation for dedicated service and forward-thinking solutions to even the most complex situations endure. eCapital keeps pace with clients’ working capital requirements from startup to growth through business transition and economic disruption with tailored services and personalized attention.

For more information about how invoice factoring supports staffing agencies through all stages of development, visit eCapital.com


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