ALTERNATIVE FINANCING AND FACTORING: UNDERSTANDING YOUR OPTIONS
Cash flow is essential to a business’s growth and survival, but creating it isn’t always easy. That’s why every business owner needs to know about the options available to them, including factoring.
In this blog post, we’ll look at four ways factoring can help businesses access the cash they need to maintain operations and fund growth. We’ll also look at four alternative financing options that are often confused with factoring.
Factoring: A critical cash source
As banks tighten lending criteria and raise interest rates, businesses are facing fewer options for accessing cash. Yet the need for cash has never been higher, as a looming recession, supply chain issues, and rising salaries place new pressure on business operations.
As a result, alternative financing (financing options offered by non-bank lenders) has become even more critical, and factoring is at the top of the list because it is one of the more affordable options. In 2022, factoring reached a U.S. market size of $3.9B.
Simplifying the terms
Factoring is a relatively simple way to free up working capital. A factor uses invoices as collateral to provide cash to businesses. Factors purchase the invoices on an invoice-by-invoice basis, advance the business up to 90% of the face value immediately, and then return the balance of the cash (minus factoring fees) when the invoice is paid.
For companies that don’t have an optimal credit rating or high-value real estate, equipment, or machinery to use as collateral, factoring can provide quick access to cash. And the cost of factoring is minimal compared to other alternative financing options such as merchant cash advances (MCAs) or online loans.
Unfortunately, the terminology for alternative financing can be confusing and prevent business owners from understanding their options.
This blog post defines the different terms used to describe factoring as well as other types of alternative financing that are often confused with factoring.
While banks are an excellent source of working capital, they require applicants to demonstrate a lengthy credit history and good credit score or own specific assets, such as business machinery, equipment, vehicles, or real estate.
When businesses don’t meet these criteria, alternative financing can provide additional options. These options can include borrowing money at higher interest rates and using current assets, such as inventory, invoices, or purchase orders, as collateral.
In addition to these alternative financing options, businesses can also consider factoring, which enables a business to sell invoices to a factor for cash. Because a factor provides cash based on the value of the invoices, they are primarily interested in the creditworthiness of the business’s customers, not the business itself. As a result, even new companies with no credit history or companies with low credit scores can access cash through factoring.
Here are four of the most common factoring terms business owners are likely to come across as they research their financing options.
Accounts receivable factoring
Accounts receivable factoring, also known as invoice factoring, is the most common term for this type of alternative financing. When a business needs to accelerate cash flow, the factor purchases the business’s outstanding invoices and advances up to 90% of the value of those invoices. The factor takes care of collecting payment and returns the balance of the funds to the business (minus the factoring fees) once the invoice is paid.
Accounts receivable financing can be ideal for many B2B businesses that experience cash-flow issues due to a lengthy payment cycle. It’s also an ideal option for companies that want flexible, ongoing access to cash on either a long-term or short-term basis.
Government contract factoring
Every year, the U.S. government awards billions of dollars of business to small and medium-sized businesses (SMBs). Government contract factoring helps businesses secure cash to fund the delivery of goods and services required to fulfill a government contract. The factor can provide the business with a letter of finance credit up front, which confirms that they are approved for factoring. Based on this letter, the business can secure contracts and terms with their suppliers. Once the business invoices the customer for the products and services delivered, the factor advances cash against the invoice so that the business can pay their suppliers and employees.
For businesses that need to ramp up quickly on short notice to fulfill a large contract, this type of factoring can be ideal.
Payroll factoring enables businesses to bridge the gap between the payroll cycles and terms of 30 to 90+ days. While this issue can affect any type of business, it can be an especially challenging issue for staffing companies because they have a high volume of payroll to cover and tend to have few high-value assets (such as real estate, machinery, or equipment) to use as collateral for a loan.
In this case, the factor advances cash against the business’s invoices so the business can meet its payroll obligations on time.
Debtor in possession (DIP) factoring
Debtor in possession (DIP) factoring is used by businesses that have filed for Chapter 11 bankruptcy protection. In this case, the factor advances cash to the DIP based on the value of outstanding invoices owed to the corporation. The DIP can then use the cash to finance the business’s operations and minimize the disruption caused by bankruptcy proceedings.
DIP factoring can help to protect the best interests of the business and its stakeholders by ensuring the business has the cash it needs to continue funding operations with the potential to generate revenue.
Other types of alternative financing
Factoring is a good way to free up the cash your business needs to meet payroll, pay suppliers, or fund growth—even if a bank loan is out of the question.
But there are other ways to access cash outside of the traditional banking system. These four types of financing are often confused with factoring. However, they are actually ways to turn business assets, such as contracts, inventory, invoices, and purchase orders, into collateral for an alternative lender.
Mobilization financing provides the capital needed to mobilize a project prior to issuing an invoice for the project. To support a business’s mobilization, a financing company may advance cash based on orders from their customers to assist with the necessary working capital to fulfill that order.
Mobilization financing can be ideal for businesses that are growing so quickly that it has become difficult to finance growth organically.
Inventory financing enables a business to use its inventory as collateral. An inventory financing company will assess the value of the inventory and advance an amount of cash based on that value. The lender is then repaid out of the funds collected when customers pay for the goods or services delivered.
Inventory financing may be a good fit for companies that have consistent orders from customers for their products. It can also help companies with a seasonal or highly variable sales cycle to smooth out cash flow or ramp up to meet anticipated growth by acquiring more inventory.
Asset-based financing can be offered by both traditional banks and alternative lenders. In this case, the company uses its existing inventory and accounts receivable as collateral. The lender typically makes advances equivalent to as much as 80% of the value of the company’s accounts receivable and between 40-50% of the cost of the company’s inventory. The lender monitors the value of this collateral weekly or monthly to ensure the loan-to-value ratio is healthy.
Unlike various types of factoring, such as invoice factoring, DIP factoring, and payroll factoring, approvals for this type of financing are based on the creditworthiness of the company and not the company’s customers.
Purchase order financing
Purchase order financing, or PO financing, helps businesses obtain the cash they need to pay suppliers so that they can purchase the goods and services they need to fulfill future or pending orders before invoicing.
This type of loan is helpful in situations where a business that receives a significant customer order doesn’t have enough liquidity to pay the supplier up front. In this case, the business can use their purchase orders to access the money they need. The lender makes the decision to provide financing based on the business’s track record of securing customers for its products and services. When the business receives payment, the loan is repaid, with interest, out of the proceeds.
While purchase order financing tends to involve a higher interest rate, it can be a good fit for young, high-growth companies that make a good profit margin on their goods and services.
Factoring means more options
If your business is unable to take out a bank loan, you have more options than high-interest private loans or costly alternative financing. Factoring gives you an affordable way to leverage the value of your accounts receivable to access cash.
While different types of factoring can seem confusing at first, the most important thing to know is that they are all based on the same idea: helping businesses turn invoices into ready cash. Whether it’s called accounts receivable factoring, government contract factoring, payroll factoring, or DIP factoring, the result is a more predictable cash flow and more working capital that can be used to protect the financial health of the business and seize business opportunities whenever and wherever they arise.
To find out whether factoring can help your business improve cash flow, talk to us.