Factoring VS Bank Loans

Factoring is very different from “traditional” lending. For one, it is definitely more expensive. But with the expense comes added flexibility and services that other types of lending cannot match. So this leads to the question: When is it a good time to switch to other types of financing?

To answer this question the business must first look at what financing options they qualify for. If factoring is their only option then it can help increase business volumes while building credit history, both of which may help the business to later qualify for a different, perhaps more ideal form of funding.

 If the business already qualifies for alternative forms of funding then there is more to consider. A traditional loan will have a fixed, periodic interest expense. Factoring provides funds based on current sales IE a more variable basis. Factoring also is an off the balance sheet form of financing, meaning that it does not create any new debt or liabilities which need to be paid back. Therefore it is impossible to get “over your head” in debt with factoring as there is no debt incurred and financing is only received after money is earned. This is opposed to loans that are borrowing against future, unearned cash flows.

The debt service that a traditional loan arrangement requires, creates a financial hurtle that businesses must manage. This can be a burden to a business that receives a large, resource consuming contract or to a business that has seasonal slow periods. In theses situations the working capital of the business will be stretched and the fixed debt service will make financial resources even tighter. However if a business has enough operating cash to deal with the aforementioned issues a traditional loan will likely be the more financially savvy choice. This is because a traditional loan allows the business to keep all of the money made above the debt service whereas factoring takes a percentage off the top of sales.

Another facet to consider when weighing financing options is how much funding your business needs. In a bank loan arrangement, not taking out enough money will eventually lead to funds running out and your business back in the same cash flow crunch. However taking out more money than can be put to use will cause unnecessary interest expense. Forecasting how much money is needed is an inherently imperfect process, and depending on your business model maybe very hard to do accurately. On the other hand, factoring offers flexible financing so that the right level of funding is available when it is needed. If your business is unsure as to how much money it needs or how much it can take on responsibly, factoring might be a safer alternative.

 The biggest determinate of whether factoring is appropriate is the business model.  As well a business with low profit margins would not be ideal for factoring as this arrangement would take away a large percentage of their profits.  For companies that engage in more frequent transactions and/or a higher volume of transactions with higher margins, factoring could possibly provide great value in managing cash flow.

 Risk evaluations and market conditions also play a role. When an industry is booming, a tradition loan could help the business make more money as the financing method will not be taking money directly of the top of their sales. As well because their interest expense is fixed, once it is covered the rest of the revenue is theirs to keep. The draw back of a loan when demand is strong is that the funds can run out and a lack of cash flow can inhibit a business’s ability to complete orders. However in slow periods, that interest fixed interest expense could be a burden. Factoring provides a more conservative alternative with the draw back of being a variable cost when sales are strong and the advantages of not being a liability and being extremely flexible.

 It is important to note that factoring and traditional loans are not mutually exclusive arrangements but rather financial tools that can be utilized together. For insistence, a smaller loan can be taken out to cover most of the businesses operational needs and factoring can be used when appropriate. When sales speed up and soak up capital a factor can be used for additional financing so that the business does not have to forfeit potential sales due to cash flow issues. As well during slow sales periods when finances might be tight a factor can be used to help meet the debt payments and other financial obligations. This is when a factor that allows the business to choose which invoices to sell, and when to sell them, becomes a very valuable tool.

Factoring also has benefits that have little to do with financing and that loans simply do not offer. Before a factoring arrangement is approved, the factor will do a credit check on the customer to ensure that they are not a risk to default on payment. This provides value to the factor’s client as they will have a better idea of how much of a risk of non-payment the companies they do business with are. As well, factors can be a consolidated source of payment. Instead of having to keep records of payments from all your customers individually, a factor will take care of that for you. They will also act as a collections agent for the customers that are slow in payment, and will resolve any issues or discrepancies that may be causing problems concerning payment. These services can be exceptionally valuable for sole proprietors or small businesses because it will affectively outsource these operations for minimal cost to free up more of their time to focus on their core business.