The end of 2015 brought the first rises in interest rates since 2006 and all indications are that more rises will follow in the coming years. This has left many small business owners asking if they should seek out financing before further rate rises. And if they’re seeking financing, should it be through a traditional loan or factoring?
The answer to the question will depend on the specifics of the small business. However, there are some generalities surrounding each of loans and factoring which are worth considering. Below, we provide some pointers on the differences between the two, which should aid you before deciding which would work best for your company’s financing requirements.
As most small business owners will already be aware, near zero interest from the Federal Reserve doesn’t always translate into cheap credit for small businesses. Even with a healthy financial performance, you can expect to pay a near double-figure interest rate, depending on the source of the loan and the perceived financial stability of your business. Intermediaries issuing loans to small businesses will take into account issues such as the credit history of the business, its operating history and what in many cases, what the loan is required for: financing long-term capital may be looked on more favourably than seeking credit for payroll expenses, for example.
All things being equal, the terms which are offered for loans are stricter than those for factoring, which means that small business owners who aren’t eligible for loan terms often turn to factoring as a plan B. Nonetheless, if a small business owner can meet the terms of a loan provided by the intermediary, this means of financing can often offer more flexibility than that provided by factoring.
Sometimes referred to as ‘invoice factoring’ or ‘accounts receivable factoring’, this is the process whereby businesses sell their invoices to a factoring firm at a discount. That is, your invoices effectively take the place of the collateral that you would typically be required to have in place before receiving a loan.
Whereas loans usually demand that your business has a strong credit history (and may charge an eye-watering premium, even if it does), intermediaries which offer factoring are instead more interested in the debtor’s credit history – as they’re ultimately the party which pays the intermediary.
The advantage for a small business of using its invoices as collateral is that the owner doesn’t have to use their own personal capital for the transaction. As a result, if the terms of the factoring are attractive, it substantially lowers the risk for the small business owner who would otherwise be using personal capital to pay for counterparty risk.
A final benefit of factoring is that it’s often faster to obtain than financial loans. In many cases, the trade-off for a small business seeking a loan within a shorter timeframe will be higher interest rates. Generally speaking, this isn’t the case with factoring, where owners can expect to receive a decision within a couple of days.
Should small business owners opt for loans or factoring? The truth is that both should be considered: by doing so, you’re at least making an informed decision. From there, closely examine your company’s requirements and measure them against the terms being offered by the loan and the factor – what fits one scenario won’t always work in another, so taking both into account gives you the best chance of maximizing the value of the financing for your business.