Cash-strapped businesses will often do whatever it takes to survive. That includes making poorly thought-out business decisions in the heat of the moment. Nothing induces panic more than the realization that you don’t have enough money coming in to cover your expenses.
When a quick payout is required, traditional loans won’t cut it. Two of the most common solutions to short-term cashflow problems are: Factoring and Merchant Financing.
While both provide businesses with much-needed cash quickly, how they go about doing it differs. What makes sense in one situation may not make sense in another. In this post we will take a look at the differences between Factoring and Merchant Financing so you can make a more informed business decision when the time comes.
Factoring Vs. Merchant Financing
Factoring is a financial transaction in which you sell your accounts receivables, or outstanding invoices, to a third-party factor. The factor buys these invoices from you at a discount and pays you a portion of the amount due immediately in cash. You may get anywhere from 80-90% of the invoice amount returned to you in cash immediately, depending on the factor. Once the invoices are in the factoring company’s hands, that company becomes responsible for collecting on the invoices from your customers. Once the customer pays on the invoice, you receive the remainder of the invoice amount due to you minus the factor’s fee, which is generally a set percentage of the total invoice amount.
Merchant Financing is a cash advance, much like a traditional bank loan. The difference is rather than accepting a check from you every month, merchant financiers take a fixed portion of every transaction the small business makes until the loan amount is repaid. The financed amount is based on your average monthly sales and projection. By including projected income in this calculation, merchant finance companies are able to charge rates that are well over prime. Needless to say, merchant financing advances come with astronomical interest rates and the loan must be paid back within a short period of time, sometimes less than a year. If the loan is not paid off during that time, the financier may claim all business income until it is.
When Does Merchant Financing Make Sense?
Because of the high interest rates and short repayment times, merchant financing almost never makes sense except as a micro-loan. If a company needs immediate cash and knows with absolute certainty that they will be able to repay the amount very soon, then merchant financing can be a good choice. They can also work as bridge financing, such as when construction costs run over and cash is needed to continue the project, but you know you’ve got or will soon have the cash necessary to repay the loan.
The loans are available much more quickly than bank loans and they don’t require collateral, which is what makes them so popular, especially with small businesses that don’t have much collateral or reliable cash flow.
When Does Factoring Make Sense?
Factoring makes sense as a more long-term solution to cash flow problems, if you want to avoid taking on debt, or if you can’t get a traditional bank loan. Since you are selling assets you already have, you aren’t taking on any new debt. There are no daily or annual interest rates to worry about repaying. The factoring service’s fees are pre-calculated based on the amount of receivables sold so there are no surprises as to the amount owed. Although you will pay a fee for the service, you know what that amount is upfront and are not locked into a monthly repayment plan.
Factoring can be used to manage cash flow when customers are slow to pay their bills or if you have immediate expenses that can’t wait to be paid, like payroll.
Take a Look at the Fine Print Before You Sign Anything
If you are strapped for cash and are considering factoring or merchant financing to help cover the gap, do your research. Take the time necessary to fully explore your options and understand the terms and conditions of the agreement.
For factoring, find out:
- What percentage of the invoice amounts you will be paid.
- What the factor’s fee is. Don’t settle for assurances of “small fees” or “low rates”,
- If there are additional fees or interest applied to past-due customer accounts, and
- What happens if the customer doesn’t pay the invoice. Will you have to buy it back, trade it for another invoice, or something else?
For merchant financing, find out:
- Exactly how long you have to repay the advance,
- The exact amount of the percentage rate and how frequently it is assessed – daily, annual, monthly, etc. It is not unusual for interest to be charged daily.
- When payments will be deducted – daily, weekly, monthly, etc.
- If your business can truly afford to make the repayments. You do not want to get locked into an agreement you can’t afford.
Finally, if you don’t understand the terms for either situation, find a different provider. It is imperative that you understand your obligations under these types of financial agreements or you may find yourself on the hook for more than you can afford to repay.
To learn more about factoring, visit National Factoring Group at www.nationalfactoringgroup.com.