With all the various types of financing tools available in the alternative commercial finance industry, the differences between the types and when to recommend them can sometimes become blurry and this is especially true between factoring and asset-based lending. Take a moment in this short article to learn the difference.
Standard financial statement bank loans work well for well-established companies with a history of profitability and solid revenue streams; but not all companies can qualify for such loans. For example, some company’s are cyclical or seasonal with strong revenues during three or four months a year and poor sales for the balance. Others may startup companies that have creditworthy, established clients they sell to but with almost no credit history themselves. These entrepreneurs may be unattractive to traditional financial statement lenders, but there are other financing options available to them in the alternative commercial finance industry and two such alternatives are factoring and asset-based lending.
Asset-based lending and factoring are both considered types of asset-based finance and both use accounts receivable as the primary source of collateral. Both provide working capital during cash flow crunches, but are different in many ways. Here are the differences.
Asset-Based Lending provides a business owner with capital in the form of a term loan utilizing a revolving line of credit that provides cash a business owner can access as it is needed. The amount of credit available to the business is based on the company’s assets, which are used as collateral for the loan. These assets can include accounts receivable (invoices), inventory machinery and also equipment. These assets are valued and the credit line represents a percentage of the liquidation value of the assets. The benefit of ABL is that the loan is based on this liquidation value so that even during temporary economic downturns and fluctuations in business, the collateral value remains stable, guaranteeing the loan availability. So asset based lending is always structured as a loan and can be used to finance inventory and equipment as well as accounts receivable and is a great option for a business that has plenty of such inventory and accounts receivable, but needs access to working capital and cash for growth.
For businesses that are young and growing rapidly or that have fluctuating sales and little or no credit history, factoring can be a ready solution to satisfy capital needs. Unlike asset-based lending, however, factoring only provides financing based upon the value of accounts receivable It is one type of asset-based lending. You can look at factoring as simply an advance of cash on outstanding invoices that are tying up existing working capital. It is never a loan of NEW working capital. Factoring simply speeds up the payment process so the existing working capital of a business is not “trapped” in invoices waiting to be paid.
Unlike asset-based lenders, factors are actively involved in the collection process. Factor take over the management of a business’s unpaid invoices/receivables. When a company generates an invoice, the factor immediately pays up to 90 percent of the invoice face amount as an advance and the factor, rather than the business owner, now waits to be paid. As part the factor’s services, the factor’s staff collects the full amount due on the invoice, repays itself for the previous advance of up to 90 percent, and then rebates the recently paid balance to the small business owner, minus a small service fee (typically ranging from 1-3 percent of the invoice).
A common use for factoring is often found in the manufacturing and distribution sectors where there is a need for inventory finance. In many instances where a business does not yet qualify for an ABL due to weak financial statements, factoring for a year or two can often help to grow that business exponentially and strengthen it’s income statement and balance sheet. Then, once it qualifies, the asset-based lender can ‘b uy out” the factor. Such “window dressing” of a business is very common and the concept helps to make a strong case for referral business when speaking with bank loan officers.