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Loans vs. Invoice Factoring: What’s Better for Small Businesses?

When you are managing a small or medium-sized business, your biggest concern is most likely securing cash flow to fund necessary operations. You can hardly hope to grow your business if you don’t have enough working capital to pay all your employees and rent.

When your business is in a pinch, you’ll most likely explore short-term funding options. Two financial products you’ll come across are term loans and invoice factoring

While both funding options have their advantages and disadvantages… 

Your business’s particular situation and specific business goals will be the deciding factor for determining which financial product is best. 

In this post, we’ll break down term loans and invoice factoring to help you decide when term loans are the right call and when invoice factoring is the right call. We’ll discuss—

  • What are term loans?
  • What is invoice factoring? 
  • What are the advantages and disadvantages of term loans?
  • What are the advantages and disadvantages of factoring?
  • What types of businesses benefit from each?

Great Funds Factoring is a Chicago-based factoring company serving the entire United States. We help small and medium-sized B2B businesses solve cash flow issues and increase working capital. Partner with us and start thriving—fill out our contact form today to learn more.  

Loans vs. Invoice Factoring: What's Better for Small Businesses?

What Are Small Business Loans (Term Loans)?

Term loans are a financial product where a lender (usually a bank) provides a lump sum of cash in exchange for specific repayment terms and either a fixed or floating interest rate. 

This financial product is generally only available to businesses with sound financial statements and established financial history. Term loans are useful for financing the acquisition of fixed assets—like a new building or for large equipment purchases.

There are several varieties of term loans based on the duration of the repayment period—

  • Short-Term Loans—a loan with a repayment window of a few months up to 18 months.
  • Intermediate-Term Loans—a loan with a repayment window of one to three years.
  • Long-Term Loans—a loan with a repayment window of three to 25 years. 

What is Invoice Factoring?

Invoice factoring is a financial service that helps businesses address various cash flow issues related to unpaid accounts receivables. Businesses that rely heavily on customer invoices for income often have to wait between 30 and 90 days for their customers to pay. 

Slow-paying customers can heavily limit a small business’s access to working capital, making it difficult to fund necessary operating expenses.    

An invoice factoring company purchases a business’s accounts receivables at a slight discount. There is no debt as the factoring company purchases a business’s assets—their A/R—directly. The final transaction settles once the customer pays the factoring company.

What’s Better? Invoice Factoring or Term Loans? 

Well, as cliché as it sounds, the answer is that it depends. But what does it depend on?

Deciding which funding option is best for your business requires some research. Many factors go into choosing which financial product is the right call. In the following section, we’ll break down some advantages and disadvantages of each.

Ultimately, the decision depends on your business goals and particular financial situation.

Benefits of Small Business Loans

Loans Are Useful For Purchasing Business Assets, Making Acquisitions, and Other Long-Term Business Decisions

Term loans are usually used to finance the acquisition of fixed assets, whether that be purchasing new equipment, satellite business, or new property. Term loans range from short-term, with a repayment period of a few months, to long-term, which can have a repayment window of 25 years.

Small Business Loans Can Be Less Expensive Than Invoice Factoring (Depending on the Terms of the Loan)

It’s important to note that invoice factoring and term loans are different financial products, so a general side-by-side comparison of each product’s cost does not paint an accurate picture. The specific terms of the loan determine whether or not it is a less costly option than invoice factoring. However, favorable short-term loans can be less expensive than invoice factoring.    

Drawbacks of Small Business Loans

Loans are Not Ideal For Funding Operating Expenses or Fixing Cash Flow Issues

Most term loans are not ideal for funding urgent expenses like payroll or rent. The potentially years-long repayment window, assumed debt, and interest rates make this product unsuitable for fixing short-term cash flow issues better addressed by other financial products. 

Loans Can Have Restrictive Covenants

Covenants are loan clauses that stipulate certain conditions that the borrower must comply with or pay an additional amount. These restrictive covenants often require the borrower to maintain specific financial ratios or hit specific revenue targets by a certain date to avoid triggering additional fees.

Loans Are Harder To Get Approved For

Lenders have more stringent approval requirements than factoring companies. To get approved for a favorable term loan, businesses need outstanding creditworthiness, an established financial history showing profitability, and enough assets to act as collateral.

New businesses (less than three years old or so) do not meet the requirements to get approved for favorable business loans. 

Loans Take Longer To Get Approved

It also takes much longer to get approved for a business loan than it does to get approved for invoice factoring. The loan approval process can take weeks or months, whereas a small business can get set up for invoice factoring in a matter of business days.

Term loans are not ideal for B2B businesses that need to solve cash flow problems immediately. 

Loans Are Debt

Term loans count as debt on your business’s balance sheet. They must be repaid per your loan’s terms and conditions. Invoice factoring is a financial transaction where a factoring company purchases your A/R. There is no debt, and the factoring company only needs to be repaid if your customers fail to pay their invoices.  

Benefits of Invoice Factoring

Factoring Is Better For Businesses That Need To Correct Cash Flow Issues Quickly

In a fast-paced B2B world, new businesses need every second they can get their hands on. Bank loans are not the ideal financial solution if your business is experiencing an immediate cash flow problem. 

Invoice factoring is suitable for acquiring upfront cash to solve pressing cash flow problems.

Factoring Is Better For New Companies That Lack Financial History

You need an established financial history to receive a favorable business line of credit or get approved for a loan with good terms. Because invoice factoring is a different type of financial product, factoring companies do not need substantial financial documentation and an established financial history to purchase your invoices. 

Factoring Has Less Restrictive Covenants Compared To Loans

Factoring companies have very limited covenants that are usually installed to protect themselves from fraud or if a client’s customer fails to pay their invoices back.

Best For Companies That Need Quick Capital To Fund Operating Expenses

Invoice factoring is useful for any company—new or well-established—that needs quick capital to cover a hole in working capital. There are many reasons why a company might need to factor their invoices—from emergencies to seasonal lulls in business. 

After Set Up, Factoring Companies Can Transfer Funds in 24 hours

Getting set up for invoice factoring takes a few business days. After your business is set up, the factoring company can often transfer funds into your account within 24 hours as they receive invoices. 

Invoice Factoring is Not Debt

Invoice factoring does not appear as debt on your financial statements because it is a business transaction—the factoring company buys your accounts receivable. The transaction officially closes once your customer pays their invoices. With recourse factoring, you only owe money back if your customer fails to pay their invoice. 

Check out our blog post to learn more about the difference between recourse and non-recourse factoring.

Factoring Companies Help With Collections

Many factoring companies help their partners collect payments from customers, which helps small businesses that don’t have a dedicated collections department or who don’t have the time to spend chasing after their customers. With term loans, there are no additional services offered.

Read our blog post on the benefits of invoice factoring to learn more.  

Drawbacks of Invoice Factoring

Invoice Factoring is Not Ideal For Funding Large, Long-Term Purchases or Other Business Assets

Invoice factoring is not ideal for financing large business investments, including purchasing property, acquiring a satellite business, or other large, long-term expenses. Loans are the better choice for these types of purchases.

With Most Factoring Services You Are On the Hook If Your Customer Doesn’t Pay Their Invoices

Invoice factoring does come with some risk. For the transaction to close, your customer must pay their invoices on time. The longer they take to pay, the higher the factoring fee becomes. If they fail to pay entirely, your company needs to pay the factoring company back for the advanced funds.

The Takeaways: Loans vs. Factoring

As you now know, one financial product isn’t simply “better” than the other. Each product is useful in different financial scenarios. 

What Type of Business Benefits Most From Invoice Factoring?

Businesses that benefit from invoice factoring are—

  • New businesses that lack an established financial history
  • Businesses that rely mostly or exclusively on customer invoices for income
  • Businesses that have cash flow issues due to unforeseen circumstances or seasonal lulls in volume
  • Businesses that need to fund operating expenses 

What Type of Business Benefits Most From Small Business Loans?

Businesses that benefit from term loans are—

  • Businesses that have an established financial history and strong credit
  • Businesses that are looking to finance a large investment, such as purchasing property or acquiring new equipment.

Great Funds Factoring Can Help Fix Cash Flow Issues and Grow Your Business

If your business is experiencing a cash flow crunch, we have cash flow solutions! Partner with Great Funds Factoring and get access to the cash you need to fund and grow your business.

Fill out our contact form to learn more about our factoring services, or if you are ready to partner with us, start your credit application today!