Financing Your Business: How is Factoring Different from Traditional Financing?

Business owners of all sizes must constantly find sources of financing. This is especially true during the initial stages of growth; however, it remains true at every level of operation. When a company requires additional funds, most turn towards traditional methods of financing. These methods vary by name and particulars, but they have one uniting factor:  they are all forms of debt. Essentially, traditional financing is when a loan is procured and then must be paid back. While this method has served the business world well for years, there are alternative forms available as well, such as purchase order financing and factoring. You may be left wondering what factoring is; factoring is a financing option your business should seriously consider

The Definition of Factoring

According to AOL Small Business, factoring is when a bank or another type of financial institution purchases outstanding accounts receivable, which are typically invoices, with a percentage of the total deducted. This gives the selling company access to quick funding for any invoice that has not yet been paid. This provides a distinct advantage to any company that qualifies for factoring by helping them avoid the cash gap.

The dreaded “cash gap” is a term that describes the period in which capital has already been expended, yet payment has not yet been received. The cash gap can be extremely detrimental, depending on the size of the outstanding order and the working capital of the company. If a company had to expend all of their working capital in order to fulfill the order, they are rendered unable to process further orders until payment is received. This is when factoring is ideal, funds can be immediately provided. Depending on the factoring company, funds may be received the next day. This allows new orders to be processed, materials to be ordered and payroll to be satisfied.

Factoring Vs. Traditional Financing

Traditional financing operates solely on debt. Some forms of debt financing are dependent upon your company’s credit, while others depend on your company’s equity. Either type of financing is based on the promise of future income. This means that securing these types of financing can be difficult as well; each bank or institution will have its own requirements for granting a loan. Depending on your company’s financial situation, securing a loan based either solely on credit or with collateral may be easy. If it is done with enough forethought, these types of financing can help cover the cash gap and allow for growth. However, they are not a fast solution, since it can take time to receive funds. Additionally, these options may not even be available due to the stringent requirements on most types of loans.

Conversely, factoring is a readily available method of securing financing. It is in no way a loan – your company will not take on any additional debt. Instead, invoices are sold to the purchasing company, known as the factor. Each factor will have their own requirements, however they are typically much easier to meet than a traditional loan. Most factors will base their decision on the creditworthiness of your customer, as opposed to your business. They will also consider the total transaction amount and the amount of transaction history with your customer. Also, consider that most factors will not grant financing if there is currently a bank lien on your company’s property or if there are back taxes owed. Otherwise, obtaining funds is a relatively simple process.

Which is Right for You?

Each company will have its own unique circumstances. Some situations will call for traditional financing, as factoring only applies to past due invoices. However, if your company is regularly encumbered by the cash gap – factoring is for you. Regularly using factoring can greatly enhance your control over your capital. Instead of waiting for fulfilled orders to be paid, simply contact a factor and request factoring services. The initial transaction may take a few business days, however future transactions can be processed within 24 hours. This means your company will never again have to wait 90 days to receive funds for a completed order. Instead, you’ll be able to move right on to the next one. 

About the Author:   Raul Esqueda is founder and CEO of 1st Commercial Credit LLC (www.1stcommercialcredit.com) out of Austin TX. Raul has experience in funding businesses of all industries and sizes within the United States, United Kingdom and Canada and has written many articles about purchase order finance, factoring and asset based lending.

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