Factoring vs. bank loans: what is best for your business?

Many small businesses sell invoices to factoring companies for ready cash. It's a great alternative to bank loans.

Factoring is an agreement whereby a company sells its invoices to a factor in exchange for an advance on a percentage of the amount of the invoices, usually around 80 percent. The deal hangs primarily on the company’s customers’ ability to pay their invoices rather than on the overall soundness of the company’s balance sheet, as would be the case with a bank loan.

The essential risk to the factor is that the customer might fail to pay. Even if that happens, the factor that offered a “recourse” factoring contract to the company is not responsible for the debt, and will still collect payment and fees. Meanwhile, the company remains responsible for chasing down the uncollected debt. This sort of arrangement represents less risk exposure than traditional lending and other activities banks use to generate income.

Banking regulations are factoring-friendly

Regulations spelled out in Basel II require banks to keep a certain level of capital in reserve so that they can deal with risks in their operations. In the wake of the recent financial crisis, the justification for such regulations seems to have become even stronger.

Since financing is secured by the sale of invoices which will eventually be paid by the contracting company, if not by the company’s customers, bank factoring services represent a more secure income stream than traditional lending. They also tend to generate higher fee rates than lending.