Cash advance vs. invoice factoring: Which should I use?
Comparing cash advances to invoices factoring
- Cash advances and invoice factoring are both commercial transactions and not technically loans.
- Both are quick and easy to qualify for, but are more costly than a business loan or line of credit.
- Cash advances are riskier than invoice factoring because they are based on projected sales as opposed to a set invoice value.
Businesses needing quick cash without the time, credit history or financial performance to obtain a conventional business loan are often attracted by cash-advance and invoice-factoring companies.
Technically, cash advances and invoice factoring are not loan products but commercial transactions. Given that businesses seeking fast capital are often ineligible for loans from brick-and-mortar banks, many turn to cash advances or invoice factoring and, as a result of a failure to do adequate research, wind up exacerbating their financial woes.
Understand these two financing products, consequently, is key to determining whether they are right for your business.
There are two types of cash advances: merchant cash advances, where a business receives capital in exchange for a portion of their future credit and debit card sales; and receiving a cash advance against future sales that are not tied to credit or debit cards — such as checks or other revenue streams, for example.
The two options work the same way. Based on the cash-advance company’s assessment of a business’ creditworthiness, it will assign a factor rate to the advance amount. A factor rate is used instead of an interest rate to express the total cost of the loan. For example, a factor rate of 1.3 on a cash advance of $10,000 means the cost of the money advanced is $3,000 (10,000 x 1.3 = 13,000).
Repayment typically begins as soon as the advance is funded, through one of the following:
- A holdback percentage, where a percentage of future sales is deducted directly by the credit card processor and sent to the cash-advance provider;
- Automatic clearing house payments, where fixed payments are deducted directly from the business’ bank account; or
- A trust account, where all sales revenue is deposited in a third-party lock box from which the cash-advance provider is paid its share.
The repayment process continues until the loan is paid back in full, plus fees.
Cash-advance amounts can range from 50 percent to 150 percent of monthly revenue and fund in as little as a few days. When the factor rate is converted into an interest rate, it is often very high, reaching 200 percent or more.
An invoice factoring company will purchase a business’ outstanding invoices at a discount in exchange for immediate cash. The factoring company will fund the majority of the invoice up front and provide the remaining balance once the invoice has been paid by the client, minus a fee. For example, if a business has $10,000 in outstanding invoices, and a factoring company charges a 5 percent fee, it will extend a total of $9,500 to the business in two installments. The first installment might be 75 percent of the total —$7,125 — and after the invoice is paid, the remaining $2,375 will be funded, minus any application fees or other charges.
The transaction can take two arrangements: a recourse factor or a nonrecourse factor. With a recourse factor, the business is responsible for a client who does not pay their invoice and is obligated to pay the difference directly to the invoice-factoring company, often with an added fee. A nonrecourse factor transfers the responsibility of collecting from the client to the invoice-factoring company. Given the added risk to the factoring company, nonrecourse factors carry higher fees.
Invoice factoring can provide up to 80 percent of the value of a company’s outstanding invoices in cash and fund in a few days. Fees are typically 1 percent to 5 percent of the invoice amount, depending on whether it is a recourse or nonrecourse factor.
Pros, cons and alternatives
Cash advance and invoice factoring are both quicker and easier to qualify for than business loans from conventional lenders, but also are significantly more expensive. If you meet lending qualifications and can afford to take the time to apply for a business line of credit or working capital loan, they can be much more cost-effective business-financing options.
Risk level differentiates cash advances and invoice factoring, and consequently their cost. A cash-advance company purchases a percentage of a business’ future sales without a guarantee of what the exact figures will be. Thus, it is usually more expensive than invoice factoring because of the risk of unclear future income.
Additionally, strict monthly payment percentages can cut into crucial cash flow and drive your business into a cycle of debt. A cash advance can be useful for a company with consistent sales and a credit history, such as a retail or food and beverage business, or for a single, large purchase that needs immediate financing. It should not be used to cover payroll and outstanding payments to suppliers, or used as a source of funding when existing business credit has been depleted.
An invoice-factoring company purchases a business’ outstanding invoices, which have a defined balance. Having the invoice amount identified lowers the risk for the factoring company, so fees are often more affordable than a cash advance. Invoice factoring can be useful for a business that needs fast cash and cannot wait several weeks for an invoice to be funded. It does, however, require a business to entrust the factoring company with contacting their clients for collections.
The interest rates of cash advances and invoice factoring are typically not dictated as an annualized percentage rate in the same manner as loans, which can make it difficult to identify the real cost of the transaction. Carefully read the fine print of the contract and ensure you are working with the financing company itself and not a broker charging additional fees. As always, compare the interest rates and total fees of cash-advance and invoice-factoring companies to ensure that your business can afford to repay the funds advanced.