Maintaining a steady cash flow can be a struggle for construction businesses. Invoices take time to get paid and there may be slow seasons due to economic and other issues that are beyond your control.
Two popular financing options to keep your cash flow going are invoice factoring and a traditional bank line of credit. Most construction companies look into these two options as they both offer them access to cash whenever they need it.
Some businesses will benefit more from going with invoice factoring, while other businesses may be better suited for a bank line of credit. This guide will compare these two methods and will help you decide which financing option will work better to meet your financial needs.
What is invoice factoring?
Invoice factoring is a financing method in which you sell your invoices to a factoring company and you receive around 70% to 90% of the total invoice amount. The factoring company handles the payment collection process. Once your invoices have been paid, the factoring company will give you the remaining amount minus the factoring fees.
Invoice factoring is a popular funding solution for cash flow issues. It allows construction parties to have access to cash whenever they are in need of immediate funds.
What is a bank line of credit?
A bank line of credit is financing provided by traditional banking institutions. When approved for a bank line of credit, you are given access to a pool of money. The total amount of this funding pool will depend on the agreed-upon credit limit.
You may withdraw cash from this funding pool at any time. When you withdraw cash, the available money decreases. When you pay back what you have withdrawn, the available cash increases. So long as you pay back what you withdraw regularly, you will always have your line of credit as a reliable source of funding.
Invoice factoring vs. bank line of credit
In order to determine what is best suited for your needs, we can compare invoice factoring and traditional bank line of credit based on the following features.
Both financing methods require you to apply to a lending business or institution before you can have access to funds. Factoring companies offer invoice factoring while traditional banking institutions are the most common creditors for a bank line of credit.
The application period for invoice factoring is much quicker compared to that for a bank line of credit. Factoring companies can give you a rate in a matter of days, while banks typically require weeks or months before they can assess whether you are fit for bank line of credit.
If you need immediate cash on hand, invoice factoring may be the better option. If application time is not an issue, applying for a bank line of credit will not be a problem.
Invoice factoring companies and banking institutions have different criteria for when to approve or reject a funding application.
Factoring companies generally look at your overall financial standing, but they also give primacy to the quality of your invoices and the reputation of your clients. Because you are selling your invoices, these factoring companies would want to know if your clients have bad credit records and would likely fail to pay up.
Banking institutions, on the other hand, are concerned about your capability to pay back the line of credit on a regular basis. They take a longer time to assess your application because they go through all your expenses and earnings to ensure that you will not be a liability. Getting approved for a line of credit does not only take time, but it can also be more difficult.
A credit limit primarily applies to bank lines of credit. When you get approved for a bank line of credit, the bank gives you access to a certain amount of cash. The maximum amount is the credit limit, and you may not borrow money beyond this value.
There is no such thing as a credit limit for invoice factoring. The money that you receive for selling your invoices depends on the amount of your accounts receivables. You are able to sell as many invoices as you want and there is no limit.
If your invoices are growing, then so will the amount that you can get through invoice factoring.
Lines of credit are overall cheaper than invoice factoring. The interest rates that banks offer are cheaper, typically just a little over a prime rate.
Invoice factoring, on the other hand, can cost up to over 5%, depending on your credit rating and the quality of your invoices. Different factoring companies also follow different pricing models. Some factoring companies will require to pay a flat fee on top of the factoring costs, and some will charge the factoring fees every 10 days or so.
A bank line of credit is a revolving fund which you can withdraw from and pay at any time. Most agreements will require you to pay a minimum amount at regular intervals, usually every month. Banks may also require you to maintain compliance with certain contractual obligations, such as keeping enough assets as collateral.
Invoice factoring is less complicated. When you sell your invoices, you receive an advance payment which is a portion of the total invoice amount, then you receive the remaining amount once your clients have paid up. The factoring company will handle the collection payment and they will take out the factoring costs before they give you the rest of the invoice value.
Flexibility of Use
Business lines of credit can come with contractual limitations regarding how you must spend the money. Some banks will monitor how you spend the money that you withdraw from the line of credit, and they can also require you to report to them if your business goes through major changes that might affect your ability to maintain a line of credit.
Factoring companies are not so interested in how you spend your advanced payment. You may spend your factoring money however you please — you may use it to pay your staff during a slow season or you can spend the money to pay for equipment repairs. Factoring companies will not look into where your money went.
When to use invoice factoring
If your business is small- to medium-sized
Invoice factoring is popular among small- to medium-sized companies that are looking for an efficient solution to their cash flow concerns. Smaller businesses may experience slow seasons at some point but they can borrow cash to keep running.
Instead of waiting for clients to pay the invoices, selling their accounts receivables to a factoring company allows small businesses to keep their cash flow going.
When your clients regularly pay within 30 to 60 days
If you have reliable clients that pay every 30 to 60 days, then you are a very good candidate for invoice factoring. By selling your invoices to a factoring company, you are able to maintain steady cash flow and the factoring company will even handle the payment collection for you.
Invoice factoring can allow you to focus on other aspects of your business while the factoring company communicates with your client and collects the payment.
When you need cash right away
Applying for invoice factoring takes less time than applying for a bank line of credit. If you need cash right away, invoice factoring will allow you to have access to the money that you need in no time.
When to use a bank line of credit
When your business is already established
Established businesses have a higher chance of being approved for a line of credit and will have more resources to maintain this credit.
When you have a line of credit, you may be required to submit accurate financial statements regularly. Not all construction companies are able to prepare financial statements that prove they are of sound status to maintain a bank line of credit.
When you have enough solid assets
You may need to have solid assets to be used as collateral when you apply for a bank line of credit. On top of that, you will have to maintain ownership of these assets if you want to maintain access to your credit line.
Consider applying for a line of credit if you own enough assets. If you have solid assets, you have a better chance of securing a line of credit.
When you have a relatively steady cash flow
If your cash flow is generally favorable and your accounts are on the bigger end, applying for a line of credit is the better option. A bank line of credit is relatively cheaper compared to invoice factoring.
Consider a bank line of credit over invoice factoring if your business is in good financial health and you can afford to meet the contractual obligations the banks require.