As businesses grow, they often need larger amounts of cash to finance their day-to-day operations. These businesses could be profitable, but are not able to bridge the cash flow gap between when they pay their obligations and when their commercial customers pay them. This challenge is acute for small businesses as they do not have much buying power over their suppliers, requiring them to pay in less than 30 days, and also lack power over their large customers who can draw out payments over 30 days. The difference between the days you need to pay your business bills and the days it takes your customers to pay is known as a working capital funding gap.
Traditional Financing: Line of Credit (LOC)
The traditional way to bridge this gap is obtaining a line of credit (LOC) from a bank. LOCs are essentially credit cards collateralized by a company’s assets. The more assets you have, the larger the LOC you can get. Different from credit cards, a company can draw cash from their account and are charged interest on the outstanding balance. They also need to pay a periodic fee, typically lower than the interest rate, based on the undrawn balance of the LOC. The challenge with getting a LOC is the bank application process. The process typically takes more than two months and demands a lot of a business owner’s attention in preparing the paperwork.
The Alternative: Factoring
Factoring is an alternative funding strategy in which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. Factoring companies are specialty finance companies that are backed by private investors; and hence, are largely unregulated and more entrepreneurial. Instead of collateralizing your assets, factoring companies purchase unpaid account receivables and pay you usually 70% to 90% of the unpaid balance. Factors hold back the remaining balance as a reserve, until customers pay the invoices. Factoring companies charge fees ranging from 1% to 6% of the invoice amounts (the discounts). The benefits of factoring is they provide immediate cash for drawn out receivables, conduct more simple and quicker applications processes than banks, collect the invoices on your behalf (saving you a lot of time), and “non-recourse” factoring companies insure the risk of not receiving invoice payments. Many small business owners believe these “value-add” services are well worth a fee premium. Factoring is typically more expensive than a LOC. A 2% discount for an invoice due in 30 days is equal to an annualize percentage rate (APR) of 24% (2% * 12 months).
Which One is Better?
As for all financing decisions, IT DEPENDS. Just because factoring can yield an APR north of 20% does not mean you should immediately discredit the option. Take a scenario in which a widget supplier wins a contract to sell its product to a large customer that represents $500,000 in profits. In order to fulfill the contract, the supplier needs to invest $50,000 to produce the widgets due in two weeks. Are you going to risk losing this account for $10,000 (20% of $50,000)? To the extent the supplier has time and has its financials in order, a LOC may be a more cost effective option yet does not provide insurance over the customer’s invoices or service the invoices on your behalf.
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