It is not unusual for small and midsize businesses to experience cash flow problems sometimes. Many growing businesses encounter financial problems due to fast growth. One way to improve cash flow and fix the issue is to use financing.
Two solutions include line of credit and invoice factoring to help improve cash flow. Here we will discuss both and what their advantages and disadvantages are. This will help you decide which type of financing is best for your business.
Business Line of Credit
A line of credit works much like a credit card. The lending institution provides you with a maximum credit limit. Whenever your business needs money to pay expenses, you request a draw from the line. This draw provides you with funds, but it reduces your available credit. When you remit a payment to repay the line, your available credit increases.
Line of credit are based on the collateral, cash flow, and credit. Lenders expect that your business has the collateral to secure the line and cash flow to make payments as needed. Lines also have covenants which means you need to follow the contractual provisions to keep the line operational. Lines can be secured by both corporate and personal assets.
A main reason why business owners have cash flow problems is that they have to offer payment terms to clients. Terms can be 30, 40, or even 60 days. The problem with waiting this long is that growing businesses cannot afford to wait that long for payment. If businesses demand immediate payments and do not offer terms, they risk losing clients.
Invoice factoring allows your company to sell your invoices to a factoring company. The factoring company provides you with an immediate payment, while they wait to get paid by your customer.
Factoring companies usually finance invoices in two installment payments. The first installment covers up to 85% of the invoice and is paid as soon as you factor the invoice. The remaining 15% is paid once your client pays the invoice in full. You can finance invoices on an ongoing basis because the line is revolving.
Factoring vs. Line of Credit
The following section we will compare both products and their features.
Lines of credit are cheap
One of the cheapest forms of financing are lines of credit. Lines are based on the prime rate plus an incremental portion. On the other hand, factoring lines tend to cost more. They work best for companies who have high profit margins. Profit margins that are at or above 15% work great. However, there are cases in which factoring can work with lower margin transactions.
Acquiring a line of credit can be hard
There are strict qualification requirements for lines of credit. Credit lines are a low-cost solution because lenders work with clients that are low-risk. Companies usually need to have a couple of years’ worth of operating experience. They must have enough cash flow and assets to repay the line. Lastly, the owners usually need to have good credit. In some cases, personal assets may have to be pledged as collateral.
Invoice factoring has easier qualification requirements. The most important requirement is that the company paying the invoice must have good commercial credit. Additionally, your company must not be at risk of an immediate bankruptcy and your accounts receivable must be free of UCC liens.
Lines of credit can take a long time
It can take a couple weeks or months to open a line of credit. Factoring lines can be established in a week or two.
Factoring has flexible credit terms
The credit limit of a line of credit is set by a combination of your need, your available cash flow, and your assets. Lenders expect to be fully covered by your cash flow and collateral and take those into consideration when setting the credit limit.
The credit limit of a factoring line is determined by a combination of the amount of accounts receivable you have from creditworthy customers, your ability to deliver services/products to your clients, and your needs.
Lines of credit can be hard to maintain
Lines of credit come with covenants. The following are some examples:
- Maintain good financial records
- Keep accurate track of inventory
- Keep a certain net worth
- Keep financial ratios at a certain level
- Advise the lender of any material changes
Most factoring lines do not come with covenants. You need to keep an invoice factoring line in place and avoid bankruptcy.
Both products require collateral
Most lines of credit need to use your assets as collateral. Lenders do make exceptions that are handled on a case-by-case basis. A factoring company needs to have your accounts receivable as collateral. Some factoring companies request more.
Which Type is Best?
Each one is good at solving a specific set of problems.
Consider factoring if your business is:
- Growing fast has good clients that pay within 60 days
- Has or had financial problems
- Cannot produce accurate financial reports
- Is out of covenant with an existing line of credit
Consider a line of credit if your business:
- Is established
- Has achieved growth maturity
- Can provide timely and accurate financial statements
- Has solid assets
- Can abide by the line of credit covenants