Short answer
The right working capital instrument depends on what created the gap. A bank operating line is cheapest and slowest. An asset based line grows with receivables and inventory. Factoring converts invoices already issued and funds in days. A revenue based advance is fastest and by a wide margin the most expensive, and should be treated as a short bridge rather than a facility.
Diagnose the gap first
- Work out the cash conversion cycle in days: days inventory plus days receivable, less days payable.
- Identify what created the gap. Growth, seasonality, a single slow customer, or a margin problem.
- Decide whether the gap closes by itself. If it does not, financing is not the answer.
A timing gap is fundable. A recurring monthly shortfall is an operating problem wearing a financing costume, and borrowing against it makes the next quarter worse.
The four instruments
| Instrument | Typical size | Speed | Relative cost | Needs |
|---|---|---|---|---|
| Bank operating line | $50,000 to $500,000 | Three to six weeks | Lowest | Two years of profitable statements |
| Asset based line | $100,000 to $2,000,000+ | Four to eight weeks | Low to moderate | A margined receivable and inventory pool, monthly reporting |
| Invoice factoring | 80 to 90 percent of eligible invoices | Days | Moderate | Creditworthy debtors, clean invoices |
| Revenue based advance | Roughly one month of deposits | One to three days | Highest | Six months of bank statements |
Two questions to ask about factoring
The table above makes factoring look simple and it is not, because two structural choices sit underneath it and both change whether it suits your business at all.
- Notification or non notification. Under a notification facility your customer is told to pay the factor directly. That is normal in some industries and unthinkable in others: if your largest account is a national retailer or a public body, being told to remit elsewhere is read as distress. A non notification facility keeps the relationship with you, costs more, and is offered only to stronger files.
- Recourse or non recourse. Under recourse, an invoice your customer never pays comes back to you and you repay the advance. Under non recourse the factor carries the credit loss, but only for the specific reason set out in the agreement, which is usually the debtor going insolvent and nothing else. A dispute about the work is not a credit loss, and it comes back to you either way.
Ask both questions before the rate. Then ask what happens to an invoice that ages past ninety days, because that is where the pricing stops looking like the quote.
On revenue based advances
They are quoted as a factor rate, not an interest rate, and repayment is a daily or weekly debit. The effective annual cost is far higher than the factor rate suggests. One, used deliberately with a defined exit, can be the right call. Two is a warning. Three is usually the reason the business will not qualify for anything cheaper for the next two years.
What lenders ask
- What created the gap and what closes it?
- Who are the top five debtors and what proportion of the book do they represent?
- How many days is the cash conversion cycle and what moved it?
- What is the repayment trigger, and what if it slips a quarter?
Questions
- How is a line of credit different from a term loan?
- A line revolves: you draw, repay and redraw, and interest accrues on the drawn balance. A term loan advances once and amortises on a fixed schedule.
- Can I use a line of credit to buy equipment?
- You can, and it is usually a mistake. It consumes the room you need for the operating cycle and repays over the wrong horizon.
- How quickly can factoring fund?
- Once the facility is set up, often within a day of submitting an invoice. Setting it up takes one to three weeks.
Where this shows up in practice
- Working capital and lines of creditRevolving credit sized against deposits, receivables and inventory, for the gap between paying suppliers and getting paid.
- Refinancing and debt restructuringConsolidating expensive or badly structured facilities into a schedule the business can actually carry.