Getting business financing can be confusing for business owners. There are a number of different products, each with its own strengths and weaknesses. With this array of bewildering options, how do you decide which product is the right one for your company?
In this article, we consider three products that help companies solve cash flow problems. The products are business lines of credit, asset-based loans (ABLs), and invoice factoring. We discuss the advantages and disadvantages of each solution, and we provide the information you need to determine which solution is right for your specific situation.
The quick answer
Generally, invoice factoring is easier to get than other products, and it is available to most companies that work with customers who have good commercial credit. Use this product if you cannot qualify for an ABL or line of credit.
Asset-based loans are harder to get than factoring, but they are easier to get than a line of credit. Think of ABLs as an intermediary product. This solution works best for companies that are somewhat established, have assets, and have a minimum need of $750,000.
Lines of credit are offered by banks and lending institutions and offer great flexibility at a low cost. They are great if you can get them. However, lines of credit are hard to get and are only provided to companies that have solid assets, a good track record, and enough cash flow to repay the line.
Understand each product
Skip this section and go directly to the rating and comparison section if you understand these products well. However, if you are looking for funding, consider reading this section before going to the comparison section.
One of the things I have found during my years working in corporate funding is that most business owners do not understand how these products work. Some may have a basic idea, but it’s often coupled with unrealistic expectations. Understanding the products is key to making a smart decision. It helps you have realistic expectations about the benefits, rates, and your chances of getting funded.
1. What is a line of credit?
Lines of credit are one of the best known and most misunderstood products. In general, a line of credit is a facility that allows you to draw funds up to a certain amount, known as the credit limit. Drawing funds from the line decreases your available funds. Paying back the line increases your funds available. The line is known as a revolving facility because you can keep drawing against it – as long as you make payments.
Qualifying for a line of credit is difficult by design. Lenders are able to provide very low costs because they work with clients who have the lowest risk of default. They look for companies that can repay the line of credit using their existing cash flow and assets. Lines may also be personally guaranteed by the principal shareholders of the company. Additionally, some banks may use the SBA as a secondary guarantor.
Lastly, lines of credit also have covenants. Covenants are contractual obligations you must meet in order to keep the line in operation. Covenants vary by lender, but, generally, you are required to keep important financial ratios at key levels, advise the bank of any material changes to the business, and keep enough assets. Learn more about lines of credit and how they work.
2. What is an asset-based loan?
The term “asset-based loan” is a catch-all term that can mean a loan against receivables, equipment, inventory, and real estate. For this article, we only use the example of an asset-based loan against receivables. These lines operate much like a line of credit.
As previously mentioned, an asset-based loan is an intermediary product between a line of credit an invoice factoring. It offers some of the benefits of a line of credit, but it’s easier to get. Also, an ABL is cheaper than an invoice factoring plan.
An asset-based loan has a limit, much like a line of credit. The limit is determined by the amount of accounts receivable that you are holding. Basically, you are getting a loan secured against your accounts receivables. To get funds, you submit a borrowing certificate to the lender. The lender reviews the certificate and funds your account. The line is usually repaid when clients pay their invoices.
Qualifying for an asset-based loan is easier than qualifying for a line of credit. ABLs are offered to companies that need more than $750,000 in regular funding and have enough accounts receivable to act as collateral. Asset-based loans can be provided to companies that have some financial problems, as long as there is a viable plan to turn around the business.
Asset-based loans can have covenants, but they tend to be easier to meet than conventional line of credit covenants. Learn more about asset-based loans and a similar product called sales ledger financing.
3. What is invoice factoring?
Invoice factoring, also called accounts receivable factoring, is a type of financing that provides you with an advance against slow-paying receivables. It is commonly used by companies that are not at the stage where they can get an asset-based loan or a line of credit. This includes companies that are new, growing, or have some financial problems.
The transaction is relatively simple because it is not a loan. Instead, factoring is structured as a sale. You sell your invoices to the factoring company in two installments. The first installment can cover up to 85% of the invoice amount. The second installment covers the remaining 15%, less the factor’s fee. Factoring is more expensive than an asset-based loan.
Getting a factoring line is relatively easy. Your company must have good commercial clients, solid invoices, and no encumbrances against your invoices. Companies often use factoring as a stepping-stone to eventually qualify for an asset-based loan. Learn more about invoice factoring and how it works.
Comparing and rating each product
In this section, we compare the three products with respect to the eight features that are most important to business owners:
1. Ease of qualification
The easiest product to get is factoring. The qualification criteria are pretty simple and easy to meet. Asset-based loans are more difficult to get. The company must have some operational experience, assets, meet a minimum volume, and be able to provide accurate financial statements. Lastly, business lines of credit are the hardest to get and have very strict underwriting requirements.
By far, the cheapest product is a business line of credit. Usually, companies pay an incremental fee over prime rate. This fee is commonly referred to as “prime + x%” pricing. Asset-based loans are more expensive than lines of credit. These, too, often use a “prime + x%” model.
Lastly is factoring, the most expensive product of the three. Factoring uses different pricing models, but it is common to pay a flat fee for an increment of time. For example, you could pay “x% per every 10 days.”
3. Time frames
Most factoring lines can be implemented in a week or two. Asset-based loans can take about a month to six weeks, depending on the complexity of the transaction. Getting a line of credit can take a month or two, depending on your lender and its funding requirements.
4. Credit limits
In a factoring line and in an asset-based loan, your funding limit is determined by the amount and quality of your accounts receivables. Both lines have credit limits that can be increased quickly, as long as you have the assets to back them.
Lines of credit use a fixed credit limit that is determined by your assets and your needs. Most lenders will not increase a line of credit, unless the client already has a track record of using one (e.g., a year).
Maintaining a factoring line is fairly easy. Other than following the procedures to fund invoices, there is usually little else you have to do. Maintaining an ABL and a line of credit requires that you comply with the lender’s covenants. However, lines of credit tend to be harder to maintain than asset-based loans due to their more encompassing covenants.
6. Access to funds
Lines of credit provide the easiest access to funds. All you have to do is transfer money from the loan account into your bank account. To get funds from an ABL, you must submit a borrowing certificate. A borrowing certificate is a short financial statement that determines how much you can borrow.
Lastly, to get funding from a factoring line you need to submit a schedule of accounts, copies of the invoices, and any backup documentation that shows that the invoices are valid.
7. Increasing the credit limit
Increasing a factoring line and an ABL is relatively simple. You just have to show the lender that you have new invoices from creditworthy clients that meet their funding criteria. This process can often be done in a couple of days.
Increasing a line of credit is far more difficult. To start, you have to show the lender that you have used the line and paid it back for a certain amount of time. Then you must justify the increase and show which assets will serve as collateral for the increased availability. This process can be quick, or it may require that parts of the line of credit go through the underwriting process again.
8. Collateral requirements
Lines of credit usually require that you give all, or most, of your corporate assets as collateral. Asset-based loans and factoring companies would like to have all your assets as collateral, but they can operate by having only your accounts receivable as collateral (this requirement varies).
Which product is best?
The short answer is that there is no “best” product. Each product has advantages and disadvantages. Instead, you should focus on what is the best product for your specific situation.
Consider a line of credit if your company is mature, has substantial assets, and has a long track record of success. Consider an ABL if your company has substantial assets but can’t qualify for a line of credit. Lastly, consider a factoring line if your business can’t get a line of credit, has cash flow problems due to slow-paying clients, and has high profit margins.