Invoice Factoring vs Line of Credit: What’s the difference?

Factoring

Involves selling accounts receivable (invoices) to a third-party finance company, known as a factor, at a discount.

Process: The business sells its invoices to the factor, which then advances a percentage of the invoice value (typically 70-90%). The factor collects payments directly from the customers and remits the remaining amount (minus fees) to the business.

Ownership of Receivables: The factor takes ownership of the invoices, assuming the risk of collecting payments from customers.

Credit Check: Approval is often based on the creditworthiness of the business’s customers rather than the business itself.

Use Case: Suited for businesses with slow-paying customers or those in need of immediate cash flow. Common in industries like manufacturing, distribution, and services.

Traditional Line of Credit

A traditional line of credit is a pre-approved amount of money that a bank or financial institution agrees to lend to a business. The business can draw on this credit line as needed.

Process: The business has ongoing access to a set amount of funds. Interest is charged only on the amount borrowed, and the credit line can be reused once repaid.

Ownership of Receivables: The business maintains ownership of its accounts receivable. The credit line is typically secured by the business’s assets and may involve a more extensive credit evaluation.

Credit Check: Approval is based on the creditworthiness and financial health of the business itself. Banks may consider factors such as business performance, collateral, and credit history.

Use Case: Suited for businesses with fluctuating cash flow needs, seasonal variations, or those looking for a flexible source of working capital. Commonly used for various purposes, including inventory management, operational expenses, and short-term financing needs.

Key Differences:

Ownership of Receivables

Factoring: Involves selling receivables to a third party.
Traditional Line of Credit: Business retains ownership of receivables.

Credit Approval

Factoring: Based on the creditworthiness of the business’s customers.
Traditional Line of Credit: Based on the overall financial health of the business.

Cash Advance vs. Credit Access

Factoring: Immediate cash advance against invoices.
Traditional Line of Credit: Ongoing access to a predetermined credit limit.

Risk of Non-Payment

Factoring: The factor assumes the risk of collecting payments.
Traditional Line of Credit: The business remains responsible

Both factoring and traditional lines of credit offer solutions for managing cash flow, but businesses choose between them based on their specific needs, the nature of their industry, and their preferences regarding ownership of receivables and customer relationships.