Factoring Vs. Line Of Credit
Written by Anne Roslin, Vice President - Accounts Receivable Financing
As more companies set invoice payment terms from 30 to 60 to 90 days, the payment delay can damage your company’s ability to operate and grow. Getting the right type of financing is one of the most important decisions that can make or break any business. When seeking to improve working capital, business leaders often compare invoice factoring or invoice financing vs a line of credit from a bank.
These two financing methods differ in their benefits and structures, which can have dramatic implications on your company’s cash flow, taxes, operations, and competitiveness. This is especially true for small, emerging businesses and seasonal businesses, where access to the right type of capital is essential to growth.
While both invoice factoring and a line of credit offer access to cash flow for businesses, they have several differences in terms of how they work, their cost structures, and the flexibility they provide. Let’s discuss them to give you a better idea of what might work for your business.
How Invoice Factoring Works
Invoice factoring (also called accounts receivable financing) is one of the easiest financing sources to secure. It is a financial transaction where a business sells its accounts receivable (invoices) to a third-party factoring company at a discount. In exchange, your business gets upfront cash from the factoring finance company immediately, which you can use to pay your bills, make payroll, buy supplies, or reinvest in your business. The factoring finance company then collects on your invoices from your customers to be repaid.
The benefits of factoring are that you don’t have to wait for payment and it’s easier to get a factoring facility than to get a loan. Unlike with loans, your company’s creditworthiness is less important to the factoring finance company than the creditworthiness of your customers. That’s why factoring can be a good option for companies that sell to well-established, stable businesses but might have long payment terms.
The Basics Behind Factoring
Factoring provides immediate access to cash, which can help businesses manage cash flow issues, especially if you’re dealing with slow-paying customers or businesses with long payment cycles.
Collateral: Factoring is based on the creditworthiness of the business's customers, rather than the business itself. The invoices serve as collateral.
Cost: Factoring typically involves fees based on a percentage of the invoice amount, which can be higher than the interest rates on a line of credit.
Flexibility: Factoring is generally less flexible compared to a line of credit, as the funding is tied to specific invoices.
Impact on credit: Factoring typically doesn't affect the business's credit score directly, as it's an asset sale rather than a loan.
How A Line Of Credit Works
A line of credit is a type of loan from a bank, lender, or credit union that gives you access to a set amount of funds you can borrow from as needed for your operations. A line of credit allows you to draw on the available funds at any time, up to a limit.
A line of credit is more difficult to get than a factoring finance facility and the process takes longer because it involves underwriting you and your business by the bank approving the line of credit. In fact, according to the Federal Reserve’s report “Small Business Credit Survey,” approval rates on loans, lines of credit, and cash advance applications declined from a high of 83% in 2019 to 68% in its latest survey in 2021.
Once your line of credit is approved, you can access the funds by writing a check or using a debit card that's linked to the account, transferring the money to your checking account, or using online banking services. You can borrow as much or as little as you need from the available credit limit, and you can use your line of credit for any business expenses.
You will need to make payments on the line of credit. Depending on the terms you agreed to, you may need to make minimum payments or pay off the entire balance each month. As you repay the money you borrowed, the funds become available again.
Keep in mind that you'll pay interest on the money you borrow from your line of credit, typically at a variable interest rate. The interest rate may be lower than fees for factoring or the interest rate you pay with credit cards, but it can fluctuate over time.
The Basics Behind Lines Of Credit
A line of credit is a flexible, low-cost financing solution offered by many financial institutions. It’s most often used by companies with solid assets, a history of success, and predictable cash flow to fund growth or cover unexpected expenses.
You apply for a line of credit, and the bank or lender evaluates your creditworthiness, income, and other financial factors to determine whether you qualify. If you are approved, the lender sets a credit limit based on your application and credit history.
Collateral: Lines of credit can be secured or unsecured. Secured lines of credit require collateral, while unsecured lines of credit are based on the business's creditworthiness.
Cost: The cost of a line of credit involves interest on the borrowed amount, which is typically lower than factoring fees.
Flexibility: A line of credit offers more flexibility, as businesses can access funds as needed and for various purposes, not tied to specific invoices.
Impact on credit: Borrowing and repaying a line of credit can affect the business's credit score, as it's a loan and the activity is reported to credit bureaus.
Overall, a line of credit can be a flexible and convenient way to access funds when you need them, but it's important to use it responsibly and make sure you understand the terms and fees associated with the account. However, many companies find it difficult to secure this type of financing because of more stringent financial requirements.
Comparing Factoring Vs. A Line Of Credit
Factoring and a line of credit can help businesses manage their cash flow, but they work in different ways and have distinctive features. Main differences between factoring vs line of credit include:
Funding Source: Factoring involves selling your invoices to a third-party (the factor) at a discount, in exchange for immediate cash. In contrast, a line of credit is a bank loan for a set amount of funds that you can borrow from as needed.
Repayment: Factoring is not a loan, so there is no repayment involved. The factor collects payment directly from your customers, and you receive the remaining amount of the invoice value, minus the fee. With a line of credit, you borrow funds and must repay them according to the terms of the loan agreement, typically with interest.
Creditworthiness: Factoring is often available to businesses with less-than-perfect credit, as the factor is more interested in the credit history of your customers. However, a line of credit usually requires a good credit score and other financial criteria to qualify.
Usage: Companies typically use factoring to improve cash flow by accelerating payments from customers, whereas a line of credit can be used for a wider range of purposes, such as purchasing inventory, covering operating expenses, or financing new projects.
Cost: Factoring fees can be higher than a line of credit's interest rate, as the factor assumes some of the risk and must cover its costs. A line of credit's interest rate may be lower, but it can increase over time, whereas factoring fees are typically fixed.
Overall, while factoring and a line of credit provide businesses with cash, they serve different purposes and are suited for different financial needs. Carefully evaluate the terms and costs of each option before choosing the best one for your business based on your specific needs, credit history, and the industry you’re in.
Equipment Finance Industry Faces Numerous Economic and Market Challenges
In mid-April, the Equipment Leasing & Finance Foundation (Foundation), released its Q2 update to the 2023 Equipment Leasing & Finance U.S. Economic Outlook, indicating that equipment and software investment growth slowed in the early months of 2023, resulting in the Foundation lowering its annual forecast for investment growth to 1 percent. The report also predicts sluggish economic growth in the first quarter of 2023 as the economy moves closer toward a recession – which the Foundation continues to expect will begin during the second half of 2023. Overall, annualized economic growth is forecast to be 0.7 percent in 2023.
Equipment Finance Advisor met with three industry leaders representing a cross-section of the equipment finance industry including Alan Sikora, CEO of First American Equipment Finance (Bank-owned), Hollis Bufferd, CEO of Star Hill Financial (Independent) and Jayma Sandquist, CMO & SVP US/CA, John Deere Financial (Captive), to provide their thoughts on the newest report and where the equipment finance industry may be heading in 2023.
We began by asking our participants to describe their view of the current economic environment, and if they agree with the Foundation and various economists that the U.S. economy will likely experience a recession in 2023.
“It seems that the current economic conditions in the U.S. continue to face challenges,” said Hollis Bufferd. “The Foundation lowering its annual forecast for investment growth to 1 percent suggests that companies may be cautious about spending and expanding operations, resulting in less opportunities for equipment financing. Businesses that did see growth in the first quarter were probably riding a wave from the fourth quarter of 2022 into early 2023. The Foundation’s expectation of a recession in the second half of 2023 is in line with the predictions from various financial experts who have been suggesting an economic downturn due to rising inflation, rising interest rates, continued supply chain disruptions and worldwide political tensions. It is important to note that this forecasting is not a science, and as we have seen in the past, there are many other variables that that can affect the economy.”
Alan Sikora said, “There is much uncertainty in the economy, resulting in an economic outlook that is as complicated as it has been in recent years. Our current thinking is consistent with many economists that a mild recession will most likely occur in the second half of the year.”
We also addressed the Foundation-Keybridge U.S. Equipment & Software Investment Momentum Monitor, which is released in conjunction with the Economic Outlook, and tracks numerous equipment and software investment verticals. According to the most recent Momentum Monitor two sectors are expanding, two are recovering, and eight verticals are weakening. For example, the report indicates “Trucks investment growth is likely to sidewind,” while “Materials handling equipment investment growth may pick up slightly.” We asked our panelists for their views on equipment financing demand in the first quarter of 2023 and if any sectors stood out for their companies.
“It is difficult to predict which sectors will see growth and which will decline. I think like everyone else, there was a panic in March of 2023, and our quarter did not end as strong as we anticipated, but we also continued to expand and invest in our people and specific sectors. Our team at Star Hill is more credit driven versus asset driven – providing different verticals to add to our portfolio, which has given us the opportunity to branch into areas outside of traditional equipment finance. Based on this diversification, we are poised for a record-breaking Q2,” said Bufferd.
Jayma Sandquist said, “There continues to be strong demand for agricultural and construction equipment into 2023. For the last several years customers have had a very strong cash position, so some finance penetration has been impacted by cash. Additionally, over the last 12 to 18 months, we saw very aggressive competitive financing offers from small- to medium-sized regional banks that had solid deposits at low rates and were able to offer very attractive lending rates to the market. Since the collapse of a few U.S. banks in March, small- to medium-sized banks have seen an outflow of deposits and we have seen less competitive offers from this segment of competitors.”
Challenges in the labor market also continue in the U.S. and these challenges have stressed many small and mid-sized businesses resulting in increased investment in equipment and technology. We were curious to learn if our participants have seen a rise in such investments – equipment and technology – to overcome current and anticipated labor shortages.
Sikora said, “There continues to be a trend toward financing capex investments in technology, automation and robotics, particularly in the manufacturing sector where labor shortages continue.”
“One of the key problems for agriculture and construction customers is access to and cost of labor. Technology in equipment that changes the labor requirements is certainly something that customers are keenly interested in," according to Sandquist.
Bufferd added, “I believe all industries including equipment finance are dealing with an experience gap. Having to pivot training to a hybrid and sometimes fully remotely experience has added to this conundrum, so yes, finding experienced employees remains difficult for small and mid-sized organizations. However, there are also opportunities to acquire talent from organizations that are downsizing and even eliminating financing programs due to the turbulent economy.”
The turbulent economy and the recent issues in the regional banking sector have also caused many analysts to predict a tightening of credit among regional banks. This tightening is already evident to Bufferd who said, “We have already seen a tightening of credit due to the issues with regional banks and this is most likely going to continue, but historically we have always seen a bounce back. It’s just difficult to determine when this will occur.”
Sandquist added, “I can’t speak to whether regional banks are tightening their credit yet, but we have certainly seen less aggressive financing offers from regional banks in the market since March.”
The Foundation produces the Equipment Leasing & Finance U.S. Economic Outlook report in partnership with economic and public policy consulting firm Keybridge Research. The Q2 report is the first update to the 2023 Economic Outlook and will be followed by two more quarterly updates before the publication of the 2024 Economic Outlook in December.
This data is highly valued in the industry and is utilized by many companies in developing their market strategies. This was echoed by Sandquist who said, “We have excellent economic resources at our parent company that we rely on as a trusted source for insights in the markets we compete in. The Foundation’s economic outlook is another source we can use to better understand what others are seeing in the financial services space.”
Section 179 and Equipment Financing
Section 179 of the IRS code is a tax deduction that allows businesses to immediately deduct the full cost of qualifying equipment and/or software purchased or financed during the tax year, up to a certain limit. The purpose of this deduction is to incentivize businesses to invest in new equipment and technology by providing tax relief.
For the 2023 tax year, the limit for the Section 179 deduction is currently set at $1,160,000. This means that businesses can deduct up to $1,160,000 of the cost of qualifying equipment and/or software in the year it was purchased or financed. Additionally, businesses can also take advantage of bonus depreciation, which allows them to deduct an additional 100% of the cost of qualifying equipment and/or software that exceeds the Section 179 limit.
To be eligible for the Section 179 deduction, the equipment and/or software must be used for business purposes more than 50% of the time. Qualifying equipment and technology can include machinery, vehicles, computers, software, and office furniture.
It's important to note that the Section 179 deduction cannot be used for equipment and/or software that is leased or rented. Additionally, businesses cannot use the deduction to create a tax loss, but it can be carried forward to future tax years.
Overall, the Section 179 deduction can be a valuable tax strategy for businesses looking to invest in new equipment and technology while also saving money on their taxes. As always, it's important to consult with a tax professional or accountant to ensure that you are eligible for the deduction and are taking full advantage of its benefits.
See: https://www.section179.org/section_179_deduction/ for more information.
Inflation Continues as Top Challenge for Restaurants, TD Bank Survey
Inflation continues to be the top challenge for restaurants as they look ahead to 2023, according to a survey conducted by TD Bank at the 2022 Restaurant Finance and Development Conference in Las Vegas, NV. The poll collected insight from 300 restaurant franchise operators and other finance professionals to identify restaurant franchise finance trends.
In addition to inflation as the top challenge that restaurant franchise professionals are facing, they also cited the labor shortage (32 percent), supply chain disruptions (16 percent) and rising interest rates (11 percent) as factors impacting their businesses. Despite concerns around inflation, operators are still finding opportunities to invest. Data uncovered that investments in physical locations remain a priority from a service perspective, though a near equal number of respondents intend to focus on developing digital and delivery services.
Labor quality and availability has been a particular pain-point. When asked to describe the labor quality and availability due to the current macro environment, 69 percent respondents said they noticed a decrease in labor quality and availability. Just 24 percent reported that they have seen an improvement in labor quality and availability.
Top Investment Plans Focus on In-Store Reimagining or Remodeling
While restaurant franchise operators face a number of challenges stemming from the current macro-economic environment, they continue to plan for the future—investing in their businesses to stay ahead of the competition. 41 percent of restaurant franchise operators said that they plan to invest in in-store reimagining, remodeling or in digital and delivery systems.
Many restaurant operators are looking to invest in technology to further streamline the process from placing an order to receiving your food, with 38 percent of operators planning to invest in technology such as a new POS, digital signage or other in-store tech and 37 percent planning to invest in mobile ordering. Respondents also reported that their restaurant franchise plans to invest in delivery service (23 percent) and alternative payment methods for speed and convenience (16 percent). Just 15 percent reported that their restaurant franchise had spending cuts planned, and 11 percent of restaurant operators selected that they have no investments planned.
“Our survey found that the majority of restaurant franchise operators plan to invest in store digital and delivery systems, as well as in reimaging and remodeling. The plethora of investment opportunities that are available to restaurant operators speaks to how much the restaurant industry is constantly changing to meet consumers’ demands,” said Mark Wasilefsky, Head of Restaurant Franchise Finance Group, TD Bank.
Restaurant Franchise Operators Report Optimism for Year Ahead
Looking ahead to 2023, two out of three (66 percent) restaurant franchise operators and industry professionals feel optimistic amid the current macro environment. However, 18 percent of respondents selected that they feel indifferent about the future of the restaurant industry and 13 percent of respondents selected that they feel negative about the future of the restaurant industry.
“Many restaurants went through a major shift during the pandemic with an increase in demand for delivery and takeout options,” continued Wasilefsky. “As many people are beginning to restart their pre-pandemic routines, restaurants are likely to see another change in dine-in options. The industry is extremely resilient, and operators must adapt to meet consumers’ demands in an ever-changing restaurant landscape.”
Wasilefsky added, "There are material challenges ahead for the industry. Below the revenue line, challenges in labor and inflation are creating compressed margins. At the same time, consumers are demanding a better digital and in-store experience, which requires an investment in their physical and digital presence. Brands with solid digital and delivery programs and up-to-date facilities will have a distinct advantage. In addition, operators with stronger balance sheets and overall better liquidity positions will be able to take advantage of this opportunity to grab market share."
Why 2023 Will Be the Year of the Portfolio
The challenges of early 2020 have come full circle in 2023. The boon of originations over the past 30 months combined with rapidly increasing interest rates and a looming recession have made 2023 the Year of the Portfolio. Delinquencies and the cost of funds are both rising and portfolios are swollen with atypical deals and asset concentrations created by pandemic stimulus. Unbalanced portfolios created by government shutdowns and supply chain disruptions are now the primary source of risk for equipment finance companies in meeting their financial expectations.
So, how did we get here – to the Year of the Portfolio – and how should equipment finance leaders respond and manage their portfolios given the challenges created by these market dynamics?
The pandemic made 2020 the Year of Uncertainty. In retrospect, the pandemic itself was not as unpredictable as the government response – total economic shutdown followed by massive stimulus. Borrowers in industries like hospitality and food service were immediately devastated by the shutdowns creating problems for the finance companies that had financially supported them. Then came the stimulus – sent in waves in an effort to reboot the economy. Money flooded into both consumer and business accounts alike. Payment uncertainty was quickly transformed into unexpected opportunity as new norms like work-from-home (WFH) and shop-from-home channeled the stimulus into ecommerce and IT products. The stimulus wave cascaded into domestic transportation services which were struggling to deal with the global supply chain and distribution disruption created by closed borders.
2020 delivered on uncertainty creating some big losses but the stimulus created opportunities for big wins in 2021 – the Year of Originations. Originations grew as much as 30 percent year over year and continued double-digit growth in many markets. Work-from-home enabled employees to work from any location creating domestic migration by lifestyle. This migration collided with an existing residential inventory shortage and resulted in a surge in construction demand. At the same time, supply chain disruptions created both headaches and opportunities as used equipment prices – driven by increased demand and lower inventories – increased by as much as 70 percent in some classes. Lessors serving the transportation and yellow iron markets found themselves awash in deal demand but often faced a lack of available equipment.
2022 became the Year of Reconsideration for many business leaders across the economy as the waves of stimulus brought double-digit inflation and the federal government predictably stepped in with the fastest interest rate increases in more than four decades. With the fast-rising prices and increasing borrowing costs, the specter of a recession took hold almost immediately and put a damper on 2022 economic forecasts. Demand for equipment finance remained high, however, as continued economic uncertainty pushed businesses away from CAPEX towards the OpEx models of leasing. But the damage was already done. Confusion set in and, as a result, business leaders reconsidered both strategy and tactics.
How Should We Respond?
As we enter 2023, many lessors now have significantly expanded portfolios packed with new partners, programs, customer relationships, and new asset types. With equipment prices crashing in some markets as supply chains try to catch up and delinquencies rising, portfolios are full of new risks as well as new responsibilities for those managing risk.
So how should portfolio managers respond to the current economic environment? As is often the case, data and analysis tools can be brought to bear to streamline processes and provide business intelligence to help evaluate and make portfolio decisions. Portfolio managers can leverage data in three different ways to ensure that they do not lose the momentum of recent growth to the erosion of portfolio profitability.
Identify and address concentrations to hedge recession risks.
The first step is to identify and address concentrations that may have resulted from unbalanced organizational activities during the stimulus period. Heavy concentrations in certain classes of equipment, for example, can present new risks if the market values of those classes decrease faster than originally expected. Industry concentrations can present portfolio risks if those concentrations are in less recession-proof industries.
If an organization has responded to higher interest rates with more True Leases, the values of assets could compound payment risk with collateral risk. FMV data streams, data streams like Sandhills Value Insight Portal, provide real time market values for used equipment moving through dealer channels and auctions that can be used to analyze existing portfolios as well as help reduce asset value risk on new originations.
Concentrations can be assessed and then balanced through syndication, customer contacts, account early-exit-strategies, and adjusted sales-by-market strategies. Indeed, in this period, portfolio managers will play a key role in helping the organization define its sales strategies for both deal profitability and risk management across the portfolio through hedging. Equifax’s recent Market Pulse illustrated how different industries perform during recessions and unprecedented trends in labor and housing will exacerbate the unevenness of recession impacts. Portfolio managers need to augment their historical recession experiences with live data from this recession to both avoid new risks and find new opportunities.
Identify and get ahead of stressed accounts.
Those accounts stressed by the recession, inflation and higher rates will need near-constant attention. Portfolio managers should expect to contact borrowers earlier in the delinquency process and with more frequent attention. Teams should be trained to recognize material financial challenges from those that are administrative in nature. Predictive tools can help determine which accounts require the most immediate and intense management.
At the start of the year, delinquencies had already risen in some parts of the economy – as inflation impacts the ability of consumers to pay living expenses. Again, economic data sources like Equifax provide insights for analysis within the portfolio. Portfolio data will show changes in payment days as well as delinquency within the existing customer base. Finance companies with DIY borrower portals will get insights from the data of their customers – who is checking future payments, looking at a buyout, or reviewing contracts for potential opportunities.
Customer teams can work with asset managers to secure additional collateral and/or guarantees, adjust terms to the benefit of both lender and borrower, or begin collection to avoid recovery costs.
Focus asset management on interest rate spreads, residuals, and renewals
Asset management will also play a key role in 2023. Smaller lessors often have funding lines with short-term interest rates that are reducing the spread on deals. Combine spread-risk with the rapid ups and downs of used equipment prices and supply chain disruption, and asset managers have a lot to do. They will need to work with portfolio managers to identify their over- exposure in certain asset classes as well as the underperforming assets that require attention at the customer level to extend payment streams, renewals, or syndication to balance overall portfolio performance. And long-term customers can be challenged during recessions, so determining the right approach is the key to maintaining the long-term earning strength of the portfolio.
Where Do We Go Now?
So what comes after a Year of the Portfolio? The surge in originations followed by the economic impact of high inflation and interest rates will stress borrowers, leading to 2024 becoming the Year of the Customer. As portfolio managers funnel lists of stressed accounts and pending contract collections to customer service teams, the volume and intensity of the effort will require help from automation. Customer-centric systems like borrower self-service applications as well as both monitoring and prediction of new delinquency risks will become essential tools for enabling a high volume of transactions and also for facilitating transparency for customers.
Depending upon the depth of the recession and further geopolitical disruption, the following year – 2025 - will likely evolve into the Year of Remarketing as lessors with leases of 36-to-42-month terms will see the surge of equipment returns from 2021 and 2022 deals coming to term. Renewals, recoveries, and end of lease remarketing will be on the mind of executives – particularly if the organization made strong inroads back into True Leasing where residuals often determine the final value of the deal.
Now is the time to evaluate your portfolio management tools and make sure that you can both determine and manage your risk exposure. Business intelligence tools can help you analyze your current portfolios and leverage data to make better, more strategic decisions that maintain financial expectations. The last few years have been unprecedented in both their economic volatility and uncertainty, but now the die has been cast and portfolio managers are front and center. How they respond, adapt, and innovate will define the next group of winners.