Factoring receivables vs. merchant cash advances: The difference
Recently, I have had several clients ask me what the difference is between factoring business receivables and a merchant cash advance (MCA). There is definitely a place for both sources of working capital, but it's really important to understand the value and role that each plays in a business with tight cash flow.
Factoring accounts receivable is perfect for a business that is experiencing or has growth opportunities, is less than 3 years old, or is in an industry that is difficult for traditional lenders to get their hands around (e.g. technology staffing). Factoring will provide the working capital in real time, which will allow a business to hire additional employees or purchase inventory to fulfill new customer orders. Factors will fund distributors, staffing companies, trucking companies, and service and manufacturing companies. Some will also factor medical and construction receivables, but those usually have more stringent programs due to the nature of the customer.
The "process" is pretty simple: When new invoices are created, they are presented to the factor for funding. The factor advances cash against the invoice — generally 85 percent of the face amount — and when the invoice is repaid, the factor retains a small percentage as their interest payment. A factor will require that the customer payments are sent to a "lock box" at a bank to ensure repayment goes directly to them.
For a small business that is growing rapidly, access to cash within a day or two versus waiting to be paid by the customer 35 days later is critical. Also, factoring is not considered to be a line of credit or a loan; it is a purchase of the receivable by the factor and the cash goes to the asset side of the balance sheet. With factoring, a business has the added benefit of receivables management, collections, credit advice on new and existing customers, and, in some instances, a credit guarantee is available. All of this helps to keep a business safe as it grows.
An MCA is a loan, and the lender uses the business' monthly sales volume to determine the loan amount. The typical borrower is a business that does not generate invoices, but rather, collects cash, checks or credit cards for its products or services (e.g. restaurants, hair salons and various retail establishments). As such, the lender's risk for repayment is greater than a factoring facility and the interest rates are considerably higher. The MCA lender will debit a business' bank account on a daily basis to ensure repayment of the loan. Some MCA lenders will even debit a company's credit card merchant account as a means of repayment.
An MCA loan is most effective when the business needs to purchase a new piece of equipment and/or new product inventory to facilitate increased sales. An MCA loan is not a band-aid for paying suppliers when a credit line limit has been reached and/or when making tax or other loan payments. As a one-time loan with daily repayment requirements, a borrower needs to make sure that they have the necessary profit margin to support the payments and still have operating capital. It can be a valuable tool, but it needs to be carefully managed by the borrower so that it doesn't stifle a business in the long run.
Freedom Business Funding offers both products, and it is readily available to answer a business owner's questions in order to determine which working capital product is the right fit for them.