It’s never been more tempting to choose the easiest or most attractive options when shopping for invoice finance or other business loan options. But how do you get it right?
The world of business finance has become littered with choices, lenders offering attractive rates or terms is a common theme.
The problem faced is centered around the mechanics of the loan. It is where you can get tripped up, hooked into a loan that doesn’t suit your need.
Here’s the common business loan types:
1. Invoice Factoring
A traditional manual funding product – The factoring company will purchase your receivables in return for immediate cash. Typically they fund up to 80% of each invoice and will contact customers to validate the invoice are bonafide.
2. Invoice Finance
Typically reserved for modern businesses that operate cloud accounting. The financier grants an upper credit limit against customers you nominate to finance. There is no interference with your customers or disclosure.
3. Fixed Term loan
You are granted a fixed loan amount which is taken up front in a lump sum. You are the required to repay the full amount over a set daily, weekly or monthly period. These can be unsecured or secured by property assets. Usually reserved for capital equipment purchases that can be depreciated over a long period.
4. Revolving Line of Credit (Overdraft etc)
Generally, the most familiar type associated with bank finance. You are granted an upper credit limit that can be drawn down against and repaid as required. These are secured by residential security and include fees for non-usage.
Fixed terms loans Vs revolving credit
There’s a common misunderstanding about how fixed term and revolving credit affect a business’s cash flow. On face value, fixed-term loans are simple, with fixed repayments over 6-12 months or more. Fixed term loans are matched well when used for:
- Equipment Purchases
- Plant & machinery
These items have a long-term value that can increase or decrease over time. Repayments are matched to the life of the item and as this item generates cash flow or increases in value it’s managed well with fixed terms.
Revolving credit (such as invoice finance) has fundamentally different repayment mechanisms and is designed to match true working capital requirements. When a credit line is granted it can be drawn upon for short-term needs such as inventory, wages, tax, marketing expenses and repaid relatively quickly or inline with sales to ensure interest expenses match it’s intended use.
Having the ability to draw and pay down credit easily (without penalty) is a key hallmark of a true working capital facility.
Here’s an example:
Let’s imagine you draw on your credit line to purchase stock that turns (sells) in 90 days. As the inventory is sold it is then repaid by your customers generating the revenue needed to purchase additional stock or to immediately repay the credit you drew down to buy the stock and reduce your interest to 0% (more on this).
You can use the credit line sparingly or continuously, matched with your cash flow cycles instead of locked in terms. Additionally, once you draw funds, you’re not required to start making repayments immediately which contradicts the reason you took the loan in the first place, the need for cash flow.
Where fixed terms are costly in this scenario:
If your business has regular or sporadic needs for capital which are for short periods, then locking into fixed terms can potentially deepen the cash flow shortage.
Let’s imagine this: You draw down on a lump sum to purchase stock that turns (sells) in 90 days. Instead of paying down the credit after the stock sells, you are locked into fixed repayments for 6-12 months. Your business will need to make allowances for the fixed amounts (or risk default) to be repaid and endure additional interest charges long past when the stock got sold and repaid.
To extend on this example further – If you draw down the lump sum for stock and your repayment term is 6-12 months you may need to pay off the loan in full (suffering early repayment penalties) before you can access funds again.
In contrast, invoice finance (not factoring) operates as a revolving line of credit.
Borrowers are issued with a pre-approved credit limit which decreases and increases as funds are borrowed and then repaid.
If you’re looking to inject capital into your company’s day-to-day operation, revolving credit will provide the correct mechanism that matches your cash flow cycle.
. . .
We regularly share our thoughts on trade finance, lending, company culture, product strategy and design.
Stak works with clients that sell to some of the largest buyers in Australia & overseas.