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SMEs naturally gravitate towards traditional financial products, such as business loans and overdrafts to meet their funding needs. However, data suggests that almost half of SMEs have found barriers to finance, with traditional lenders frequently making lending decisions based on credit, of which higher risk business, such as start-ups, Phoenix and smaller businesses have very little.
On the occasions that businesses are accepted for a short-term loan, the lender may not fully understand the sector in which the business operates and the loan can fail to offer the flexibility needed by these fast-growth businesses. In short, off-the-shelf business financial products haven’t always been the most practical for these businesses. This has led to many business owners turning to invoice finance (factoring and invoice discounting) to secure flexible funds for improved cash flow and to make investments in future growth.
Here we compare the pros and cons of invoice finance and business loans.
Invoice factoring is a practical solution for businesses that have a predictable flow of payments from reliable customers but need a short-term cash flow boost. It’s a flexible form of finance as it fits the needs of the business at the time 0but can also grow in line with business sales. There are variations on the factoring theme, such as ‘spot factoring’ also known as ‘single invoice factoring’, which enables the business to factor an invoice without entering into a long-term relationship with the factoring company once it is paid. ‘Selective factoring’ is when the business chooses specific customer accounts to factor.
Factoring involves buying unpaid invoices at a discount from the business and making a profit when the invoice is paid in full by the customer. The factoring company typically pays the business in two instalments for the unpaid invoice: an advance of around 80% to 90% of its value, which frequently enters the business within 24 hours of raising the invoice. The second instalment or balance is paid once the invoice has been paid by the customer, minus service fees. As service fees are associated with each invoice that the company sells on to a factoring company, this type of finance is suitable for businesses that have a small number of high-value invoices.
The factoring company bases its funding decisions on the credit strength of the business’ customers rather than the creditworthiness or trading history of the company, which is how the banks assess risk. As long as the business has a steady stream of reliable customers, a bank statement with negative balances will not be a hurdle to using this type of finance. However, a personal guarantee from a company director may be required.
Advantages of Invoice Finance
One of the considerable benefits of invoice finance is that it gives businesses access to finance as soon as the invoice is raised by releasing around 90%, sometimes even 100%, of the value of the debtor book once the invoice is issued. Invoice finance, specifically factoring, can also improve cash flow by managing credit control and the collections process, making it more likely that customer payments are received on time. Adding to these benefits, it’s a revolving facility and an extremely flexible option that can adapt to changing circumstances so when sales grow, the amount that can be released through unpaid invoices will also grow.
Disadvantages of Invoice Finance
Traditionally, SMEs have been put off invoice finance because they have been required to commit all or a large proportion of their debtor book to the financial provider. However, this is no longer the case as a number of new products have been introduced, such as selective invoice finance that brings the considerable benefit of more flexibility by allowing businesses to choose which invoices to sell as and when they are required.
That said, invoice finance still requires more administration in-house than a business loan and if the business doesn’t get the agreement right, this can cause problems in the future and can be difficult to solve.
Businesses looking for one-time funding, rather than flexible finance that grows with the sales of the business should consider unsecured business loans. That said, may lenders can extend or renew this credit line if the needs of the business change. Unsecured loans are typically approved for up to 90% of the business’ monthly sales and payment terms range from 3-12 months. In a similar vein to invoice factoring, unsecured loans can provide businesses with a fast cash injection as funds are deposited into the company account within 24 hours of approval.
Lenders collect the principal amount (the percentage of the monthly payment that reduces the amount owed on a loan) plus interest at a variable or fixed rate, depending on the terms of the agreement. Interest rates for an unsecured loan tend to be higher than those for secured loans as they are perceived to be a higher risk by the lender due to the lack of security. In short, the higher interest rates, smaller loan amounts and shorter terms offset the lack of security. This is why the majority of alternative finance providers, such as invoice finance or asset-based lending, secure an asset against the loan.
To qualify for an unsecured business loan, lenders consider the company’s trading history, turnover, growth projections and credit history to assess the interest rate, amount and term of the loan. This type of finance is a good solution for established companies that have an excellent trading history. Another crucial benefit is that no assets or home are at risk.
Advantages of Business Loans
Businesses naturally gravitate to the banks and short-term business loans are one of the most traditional routes to finance available and frequently the option that business owners consider first. However, it is vital to understand that business loans are only likely to be accepted if the business has a sound credit history and the owner can show that he or she has a viable business model. One of the main benefits of business loans is that they have a fixed-rate of interest, albeit a high one, which means that repayments will remain the same every month for the next 12 months to 10 years, depending on the repayment terms.
Disadvantages of Business Loans
However, business loans can be expensive and inflexible as the business borrows a lump sum that has been agreed with the bank. It may subsequently become apparent that not all of the loan is required or that the business needed more than it initially thought. This can be a tough one to solve.
Whether your business needs a short-term cash injection to ease cash flow pressures or sustained, flexible finance, please call 08000 746 757 or email email@example.com for free and confidential advice from one of our professional advisers.