If you own a small business, you’ve learned pretty quickly that your predicted and actual cash flows don’t always match. A dip in sales, unexpected expenses, and unplanned opportunities can all create demand for additional cash. Whatever the cause, a lack of cash can be extremely damaging to your business and can lead to wasted opportunities at best, bankruptcy at worst.
Cash crunches occur all the time. The best way to respond depends on your particular circumstances. We’ll explore two popular methods: Invoice factoring and business lines of credit.
Factoring is the sale of your accounts receivable (A/R) invoices to a bank or finance company. It is often used by business-to-business companies that sell on credit. Invoicing is seldom used for retail sales now that most are handled by credit cards, although there are some exceptions. For example, a business supplies store might sell to local businesses on an account even though the general public invariably uses credit/debit cards or cash.
Accounts receivable is your ledger for tracking money due from credit sales. As collections come in, you apply them to open accounts and reduce the amount outstanding receivables. You can prepare an aging report that ranks open accounts by age. Accounts over 90 days past due might be uncollectable and require you to write them off.
Working capital is your current assets, such as cash, A/R, and inventory, minus current liabilities. Noncash current assets convert easily to cash. You need cash and credit to, for example, restock your inventory so that you can continue to make sales. Thus, any process that speeds up your cash flow can increase your inventory turnover and enhance net income. By factoring your invoices, you are hoping to reduce the average collection time and thus increase cash flow. The net cost of outsourcing partially offsets this increased cash flow.
In invoice factoring, you sell your A/R to a factor (a bank or finance company) for cash up front and more upon collection. For example, the factor might initially pay you 80 cents on the dollar for your A/R. This is an immediate cash flow you can use to buy more inventory, pay down liabilities, expand your operations, etc. When the factor collects on an account, it forwards you a portion of the remaining cash (in our example, the remaining 20 percent minus its finance fee).
Some factoring contracts require the factor to buy all your open invoices. Alternatively, the contract might allow you and/or the factor to pick which invoices will participate in the arrangement.
When a customer defaults on an invoice, the consequences depend on your factoring contract. A non-recourse agreement is one in which the factor absorbs the loss. The non-recourse sale of the A/R invoices doesn’t create debt for your company – it’s simply the exchange of your A/R for cash. In a recourse agreement, your business is on the hook to make good on any write-offs. That creates a contingent liability for the estimated write-off amount.
An Assignment is a variation on factoring. When you assign your A/R book, the factor receives the rights to the A/R receipts and pays you a cash advance on the value of the book. You must sign a promissory note using A/R as collateral. The lender charges a fee and interest on the cash advance. You continue to collect the A/R payments and forward them to the lender. The lender has recourse — you must make good on any defaulted accounts. An Assignment is a loan arrangement that creates a liability.
The cost of factoring is the fee charged by the factor. The fee is deducted from the invoices the factor collects. The cost of assignment also includes interest on the loan collateralized by the A/R book.
Business Line of Credit
A business line of credit is a revolving loan arrangement between your business and a bank or finance company. The lender establishes a maximum loan balance. At any time, you can borrow, or draw, against the credit line up to the maximum loan balance. You can reuse your credit line again and again as you repay your balance.
Much like a credit card, you must pay at least a minimum amount each month. You are charged interest on your daily open balance, and there is no grace period as there is with a credit card. You are not charged interest for untapped funds in your credit line – if you don’t draw from the account, you pay no interest. A business line of credit is flexible because you can quickly borrow money as you need it without repeatedly applying for separate loans. This makes sense when you know you will need to supplement your cash flow several times throughout the year.
Factoring and business lines of credit share certain similarities:
- Cash infusion: Both financing techniques provide an immediate cash flow for your business. You can use the cash flow as you see fit.
- Third party: Factoring and business lines of credit both involve a third party – the factor or lender.
Factoring and business lines of credit differ in several ways:
- Accounting: The sale of invoices to a factor without recourse creates no liabilities for your company. You record the transaction as a sale. In a recourse arrangement, you will want to create a contingent liability for the anticipated write-offs. In an assignment, you create a liability for the short-term note you sign. A business line of credit creates a liability for the balance on the account, which affects your financial ratios (such as debt/sales or debt/book value) and may lower your credit score.
- Access: To access factoring arrangements, you must have invoices. Many companies, especially retailers, sell to customers using credit/debit cards or cash, and there is no opportunity for factoring. A business line of credit is open to any business that meets the credit requirements of the lender. You can see common requirements on LendEDU. If you have a poor credit score, you might not be eligible for a line of credit, or you might be restricted to a low maximum balance.
- Underwriting: Factors are less interested in your credit score than in the creditworthiness of your customers. In assignments, your A/R book acts as collateral for a loan. For business lines of credit, lenders look at your creditworthiness in gauging the line amount and interest rate, as lines of credit are usually unsecured.
- Cost: Factor fees might be higher or lower than interest rates, depending on your credit score, the prevailing level of interest rates, and the history of your customers’