“It takes money to make money.” We’ve all heard the phrase. It’s especially true for small businesses.
But it’s harder than ever for small businesses to secure the financing they need to operate. Interest rates are the highest they’ve been in decades and banks are tightening lending standards. Small businesses are feeling the crunch as inflation drives up prices and supply chain challenges persist.
In 2021, only 31% of small businesses that applied for a loan received the funding they sought. This number has been steadily declining for several years. As a result, many small businesses are looking towards non-traditional financing options like invoice factoring to bridge gaps in cashflow and address short-term needs.
Read on to learn more about traditional and alternative small business financing options and how to choose the method that works best for your circumstances.
Traditional Debt Financing
Most of the more common, conventional small business funding approaches incorporate debt financing. Debt financing involves borrowing money from a bank or other lender to fund business operations. The borrower repays the debt to the lender over an agreed upon time period (typically via small monthly payments) plus interest.
Debt financing has advantages and drawbacks to consider compared to alternatives.
| Pros | Cons |
|---|---|
| Borrower retains ownership and control of business | Borrower must pay interest |
| Payments are regular and predictable, allowing for simplified financial planning | Payments must be made regularly, regardless of business seasonality or other external circumstances |
| Debt payments are tax deductible | Approval may be difficult, requiring good credit and proven business history |
| Businesses can leverage a relatively small amount of capital into significant business opportunities | Failure to repay debt may result in serious financial ramifications and risk to business assets |
Businesses can access debt financing with a number of flexible options. Some of the most common types of debt financing include bank loans, Small Business Administration (SBA) loans, business lines of credit and credit cards.
Bank Loans
Bank loans are financial products offered by banks and other financial institutions. These loans are structured agreements wherein the borrower receives a specific amount of money and agrees to repay it over time, usually with interest.
Bank loans are ideal for businesses seeking funding for significant investments, such as big-ticket machinery, technology systems or facility renovations. Alternatively, businesses may choose to pursue a bank loan to build business credit and fund day-to-day operations, including rent and payroll expenses.
One of the main advantages of bank loans is that they provide access to a substantial amount of money that can be repaid in manageable installments. Additionally, bank loans often come with lower interest rates compared to other forms of borrowing, like credit cards.
The bank loan application process can be time-consuming and involve strict eligibility criteria, making it challenging for some borrowers to qualify. Moreover, taking on debt through bank loans carries the risk of default, leading to negative consequences like a damaged credit score or asset seizure.
SBA Loans
SBA loans are government-backed financial products designed to support and assist small businesses in securing funding.
SBA loans offer numerous advantages, including lower down payments and longer repayment terms than traditional bank loans, making them more accessible to businesses with limited financial resources. Additionally, government backing reduces the risk for lenders, potentially leading to more favorable interest rates for borrowers.
However, the application process for SBA loans can be complex and time-consuming, requiring thorough documentation and specific eligibility criteria. Despite these challenges, SBA loans remain a valuable resource for small businesses seeking essential capital to achieve their goals.
Business Lines of Credit
Business lines of credit are flexible financial arrangements that allow businesses to access a predetermined amount of money from a lender. Unlike traditional loans, where a lump sum is provided upfront, a business line of credit lets the borrower withdraw funds as needed, up to the approved limit.
This financing option is ideal for businesses facing fluctuating cash flow needs, seasonal expenses or unforeseen operational costs. The main advantage of a business line of credit is its flexibility, as it provides ongoing access to funds without the need to reapply for a new loan each time. Moreover, interest is typically charged only on the amount used, offering potential cost savings. However, Inc. recently reported that 17% of small business owners were not satisfied with the amount or terms of their latest credit line, up from 9% a few months ago.
The application process for a business line of credit can involve rigorous credit checks and documentation, and interest rates might be higher than traditional loans. Businesses should manage a line of credit responsibly to avoid overextending themselves.
Credit Cards
Business credit cards are financial tools that provide companies with a revolving line of credit for making purchases and managing expenses. They are best suited for small to medium-sized businesses looking for a convenient way to cover operational costs, travel expenses and other business-related purchases.
Business credit cards offer several benefits, including ease of use, flexibility and the potential to earn rewards or cashback on eligible purchases. They also help separate personal and business expenses, simplifying financial management and record-keeping.
Misuse of business credit cards can lead to high-interest debt, affecting a company’s financial health. Additionally, interest rates can be relatively high, and some cards come with annual fees. Responsible use and clear expense tracking are essential to reap the rewards of business credit cards while avoiding potential drawbacks.
Alternative Financing Methods
In addition to traditional financing options, small businesses can explore alternative methods that provide flexibility and innovative approaches to funding. One such method is invoice factoring, which offers a unique way to manage cash flow.
What Is Invoice Factoring?
Invoice factoring, also known as accounts receivable (AR) factoring, is a financial transaction where a business sells its unpaid invoices to a third-party financial company, known as a factor, at a discounted rate or for a nominal fee. The primary purpose of invoice factoring is to improve the business’ cash flow by obtaining immediate funds for invoices that would otherwise be paid at a later date.
Invoice factoring is beneficial for businesses experiencing cash flow challenges. It allows them early access to funds they have not been paid yet, on a per invoice basis, which can be used to cover operating expenses, invest in growth opportunities or meet other financial obligations.
How Does Invoice Factoring Work?
The process of invoice factoring typically follows the steps outlined below.
- Business and factor enter an agreement: The business accepts an agreement to work with a factor. The agreement outlines the terms and conditions of the arrangement.
- Business and factor select invoices: The business and factor determine which invoices to finance based on the factor’s eligibility criteria.
- Factor advances funds: The factor evaluates the invoices. Once approved, the factor advances funds to the business minus a fee. For example, if a business finances a $1,000 invoice, it may receive $970 ($1,000 – 3% factoring fee).
- Factor collects payment: The factor takes over the responsibility of collecting payment for the invoice from the business’ customer.
- Factor completes transaction: When the business’ customer pays the invoice, the factor keeps the full amount and closes out the transaction.
Benefits of Invoice Factoring for Small Businesses
Invoice factoring offers a number of unique benefits for small businesses.
Improves cash flow: One of the primary benefits of invoice factoring is that it provides immediate cash to the business. Rather than waiting for customers to pay their invoices, the business receives a portion of the invoice value upfront from the factoring company.
Simplifies collections: By outsourcing the collection of payments to the factoring company, the business can focus more on its core operations rather than spending time and resources chasing down unpaid invoices.
Extends debt-free financing: Invoice factoring is not a loan, so it doesn’t add to your business’ debt burden or require collateral. This can be advantageous for businesses with limited assets or seasonal business swings.
Offers easy qualification: Invoice factoring is often easier to qualify for compared to traditional business loans. The factoring company’s primary focus is on the reliability of your customer rather than your business. This makes it a viable option for businesses with less-established credit histories, as this method of financing does not require a credit check.
Despite these benefits, it’s important for small businesses to carefully consider the fees associated with invoice factoring. In some cases, factoring can be more expensive than traditional financing options, so be sure to weigh the pros and cons against your business’ needs and unique financial situation.
Eligibility Criteria for Invoice Factoring
Not all invoices are eligible for factoring. Typically, a factoring company will consider the following.
B2B or B2G transactions: Invoice factoring is usually available for business-to-business (B2B) or business-to-government (B2G) transactions. It might not be suitable for businesses that primarily serve individual consumers.
Customer’s trustworthiness: Factoring companies assess the reliability of your customers because they depend on the customers’ ability to pay your invoices. Customers’ payment histories establish your eligibility for factoring.
Invoice quality: Invoices should be accurate, complete and valid. Any disputes or inconsistencies in invoices could affect your eligibility for factoring.
Industry: Some factoring companies may not accept invoices from certain industries due to their inherent risk or unique billing practices.
Amount: Some factoring companies might have minimum and maximum invoice amounts for eligibility. Ensure that your invoice sizes meet their requirements.
Is Invoice Factoring Right for Your Business?
Before entering into an invoice factoring agreement, thoroughly research and compare different factoring companies. If you have an existing trusted relationship with a lender or payment processor, ask if they have early payment options.
Review their terms, fees and customer reviews to find a reputable partner for your business’s financing needs. Always read the contract carefully before making a decision. And always make sure your lender is in compliance with local predatory lending laws.
Invoice factoring offers faster approval and easier qualification than traditional debt financing methods like loans and lines of credit. It’s ideal for companies experiencing a temporary gap in cash flow. But you may end up paying higher fees depending on your specific factoring terms.
In today’s difficult lending climate, invoice factoring provides small businesses with an alternative method to finance their operations.