Authored by Phil Cohen
In 2024, interest rates are high, supply chains are still experiencing hiccups, and costs simply aren’t coming back down. These factors mean many businesses find themselves short on cash when bills are due, especially when their customers have extended repayment terms. Two options for companies in this situation are traditional bank funding and invoice factoring.
Learn the difference between these two methods of accessing cash, their pros and cons, and how to choose the best funding solution for your business.
What is Factoring?
Factoring is when you sell your unpaid invoices to a factoring company. They advance you a portion of the value of the invoice up front (usually 80%-90%) and take responsibility for customer payments. After the customer pays, you receive the remaining 10% less a factoring fee. Factoring is a fast way to access cash you’ve already earned but haven’t yet received.
Pros and Cons of Factoring
Pros
- Immediate cash: Get your money fast without waiting for your customer to pay
- No debt incurred: Factoring isn’t a loan, so it doesn’t affect your balance sheet
- Not credit-based: You’re selling invoices, which means you’ve already earned the money.
Cons
- Monthly fees: Factoring companies charge monthly fees that are often between 1.5% and 2.5% of the invoice value
- Outsourced customer contacts: Factoring gives responsibility for chasing payments to the factoring company, which removes your direct contact with the customer over payment
What is Traditional Funding?
Traditional funding, on the other hand, includes methods such as bank loans or lines of credit. With a traditional loan like that, you must apply to the bank, submit to a credit check, and wait through days or weeks of underwriting before finding out whether you’ve been approved. Then, you’ll need to repay the loan principal plus interest. While it can provide access to larger sums than invoice factoring, it won’t be as fast or as flexible.
Pros and Cons of Traditional Funding
Pros
- Lower APR: Traditional funding may have a higher interest rate, but it can work out to a lower APR (annual percentage rate) when accounting for the total loan term
- Larger amounts: Traditional loans can provide access to large amounts of cash
- Fixed repayment terms: Repaying a loan can be done over a period of months or years with fixed interest and payments.
Cons
- Lengthy process: It can take a long time to be approved for a business loan and you must submit to underwriting
- Strong credit required: Banks usually want to see a strong credit score and/or sufficient reserves for a loan
- Debt accumulation: Traditional funding is debt, meaning it will add to the liabilities on your balance sheet
Factoring vs. Bank Loans
If you’re already familiar with bank loans, you might wonder why you wouldn’t just go straight to the bank if you need capital now. While traditional funding is often the default for many businesses, there are some key differences between loans and factoring to keep in mind.
| Factoring | Traditional Funding | |
| Speed | Fast access to capital | Must apply, submit to underwriting, and wait for approval |
| Credit | Based on the account debtor’s credit | Strong credit history required |
| Flexibility | Use it as and when you need it | Long and formal application process and large loan amounts mean you need to plan ahead |
| Cost | Monthly factoring fee until invoices are paid | Typically involve loan origination fees plus fixed or variable interest on the total sum borrowed |
- Speed of access to cash: It typically takes weeks (or even months) for the bank to process your loans and disburse the funds. Factoring can give you immediate access to your cash.
- Creditworthiness: Banks require a strong credit history to ensure that lending to you won’t be a risk. Factoring relies on your customer’s creditworthiness, since the factoring company will be going after them for repayment, not you.
- Flexibility: You can choose when to factor your invoices, and use the service only when you need it. With a loan, you request a total loan amount upfront. Even if you don’t end up needing all of the funds, you’ll still owe interest on all of it.
- Cost: Loans charge interest on the total amount borrowed, and often tack on origination fees, late payment fees, account fees and other charges. Factoring charges a fee that is typically assessed on the value of the invoices and is charged each month until your customer pays the factoring company.
Which Option is Best for Your Business in 2024?
Sometimes you need access to working capital, whether to meet payroll, buy fuel for your equipment, or purchase additional inventory. If you can’t wait the 30 or 60 (or 90) days until your customers pay their invoices, you can borrow the money through a traditional bank loan, or you can factor your accounts receivable. The best option for you depends on a few factors:
- Does your business experience frequent cash flow gaps? For many businesses, the problem isn’t a lack of money, it’s that you don’t have the money yet. If your business typically experiences frequent gaps between your expenses and your customers’ repayment, factoring might be a suitable bridge between the two.
- Does your business have bad credit? To use a traditional business loan, you’ll need a strong personal credit score or business credit history. Without it, you either won’t be able to access credit, or the interest rates could be prohibitive. If you have strong credit, that shouldn’t be a problem. Factoring doesn’t depend on your creditworthiness, but rather that of your customers, as they are the ones the factoring company will follow up with for repayment.
- Do you need access to large amounts of capital? If you are planning large capital outlays (such as for facilities or equipment), you may need the larger loan amounts available with traditional funding. If you simply need to bridge the gap between your bills and your customers’ payments, factoring may be the better option.
The Bottom Line
Factoring isn’t the right solution for every use case, or every business. But when you need flexible, immediate access to working capital without depending on a strong credit history, factoring can be the better option over traditional funding.
If factoring is the right choice for your company, a factoring broker can streamline the process of determining which factoring company to use. Contact us to connect with the right factoring company for your needs.