Managing a business means carefully balancing cash flow, especially when waiting for customer payments to arrive. Whether you’re a small business covering payroll or a growing company looking to seize new opportunities, a bank overdraft facility or invoice factoring can offer the financial support you need.
For businesses of all sizes, cash flow is critical, especially when customer payments are delayed. To bridge these gaps, many businesses turn to either a bank overdraft facility or invoice factoring. Both offer a way to manage cash flow, yet each solution brings distinct advantages and trade-offs. In this article, we’ll break down the differences between a bank overdraft facility and invoice factoring to help you make an informed decision.
What is a Bank Overdraft Facility?
A bank overdraft facility provides short-term credit by allowing businesses to withdraw more money from their bank account than what is available, up to an agreed limit. Overdrafts can be useful for managing unexpected expenses or temporary cash flow shortages.
Here’s how it works:
- Your bank approves a credit limit based on your financial profile.
- You withdraw funds as needed, with interest charged on the amount overdrawn.
- As funds are deposited into the account, the overdrawn position reduces accordingly.
Pros of a Bank Overdraft Facility:
- Flexible Access to Funds: You can access cash as required, only paying interest on the amount overdrawn.
- Quick to Obtain: Overdrafts are usually easier to arrange than traditional loans, making them ideal for short-term needs.
Cons of a Bank Overdraft Facility:
- Potential for Reduced Limit: Banks can reduce or withdraw the facility at their discretion, making it less stable for long-term planning.
- Limited Credit for Small Businesses: Overdraft facilities are based on creditworthiness, so newer or smaller businesses may struggle to secure an overdraft limit sufficient to meet the business’s requirements. .
- Funding Limitations: Overdraft facilities are not linked or measured in comparison to the growth in turnover and as such, not an ideal financial instrument for growing businesses
What is Invoice Factoring?
Invoice factoring is a financial solution that allows businesses to sell their outstanding invoices to a factoring company for immediate cash. The factoring company, also known as a “factor”, takes over the responsibility of collecting the invoice payment from your customers.
Here’s how it works:
- Your business invoices customers for products or services delivered as normal.
- You sell these invoices to a factoring company at a discounted rate (usually 70-75% of the gross invoice value).
- The factor collects full payment directly from the customer.
- On payment by the customer, the factor pays over to you the retained portion (30-25%) net of their fees.
Pros of Invoice Factoring:
- Immediate Cash Flow: Invoice factoring allows you to convert unpaid invoices into cash quickly, ensuring steady access to funds for operational needs.
- Outsourced Collections: The factoring company manages collections, which frees up your team to focus on business growth.
- Accessible for Businesses with Low Credit Scores: Since approval is based on your customers’ creditworthiness, factoring is an option for businesses with a less established credit history.
- Scalable Funding Line: Invoice factoring is geared towards businesses with growth aspirations and as such, facilities are often increased proportionally to turnover. Managing your cash flow has never been easier!
- Discount opportunities. By having 70-75% of the invoice value available immediately allows a business to pay their suppliers upfront and to take advantage of discount opportunities on offer. Many a time, these discounts offset the cost of invoice factoring.
- Current Asset: The basics of invoice factoring is the sale of an invoice to a factoring institution, and as such, it is not classified as a form of borrowing. Your invoice factoring exposure is classified as a current asset, not a current liability as the case with an overdraft facility (Effectively off balance sheet funding).
Bank Overdraft vs. Invoice Factoring: Key Differences
When comparing a bank overdraft facility with invoice factoring, each option offers unique benefits.
Eligibility Requirements: Bank overdrafts often depend on your business’s creditworthiness, while invoice factoring relies on the creditworthiness of your customers. This makes factoring accessible to businesses that may not qualify for traditional overdraft facilities.
Cost Structure: Overdrafts charge interest on the overdrawn balance, which can fluctuate. Factoring fees, on the other hand, are typically fixed as a percentage of the invoice value.
How to Choose the Right Option for Your Business
Choosing between a bank overdraft facility and invoice factoring depends on your business’s size, industry, and cash flow needs.
- Smaller or Newer Businesses: Factoring is often ideal for SMEs with less established credit. It provides consistent cash flow without the need to qualify based on your credit history.
- Established Companies with Strong Credit: A bank overdraft may be preferable if your business has a good credit rating and can absorb the fluctuating costs, as it allows you to maintain full control over customer accounts.
- Customer Payment Terms: If you deal with clients who take time to settle invoices, factoring helps bridge the cash flow gap. Overdrafts, while flexible, may not cover extensive cash needs on a long-term basis.
- Cost Sensitivity: For businesses sensitive to high service fees, overdrafts might be the less expensive choice. Factoring, however, bundles debt collection into its costs, which can be an advantage if your team lacks the resources for credit control.
Final Thoughts
For businesses looking to streamline cash flow and avoid the hassles of delayed payments, Merchant Factors’ invoice factoring service offers a straightforward solution. With quick access to funds, support for collections, factoring is especially helpful for SMEs in South Africa needing reliable capital to cover operational costs and support growth. If you’re interested in freeing up cash flow without adding debt or managing high bank fees, Merchant Factors is here to help.
