Invoice Factoring vs. Line of Credit: Which Is Right for Your Business?

Cash flow gaps are a common problem for many small businesses — and a business line of credit and invoice factoring are two common solutions business owners turn to. Each of these options can offer your business the funding it needs, but they also come with their own pros and cons.

How do you determine which is the right option for your business?

Let’s take a look at the difference between invoice factoring and a business line of credit, explore how each option works, and address a few of the factors you should consider when making a decision.

Factoring vs. line of credit: What’s the difference?

The main difference between invoice factoring and line of credit is how they allow your business to access funds. Invoice factoring is tied to your accounts receivable, turning unpaid invoices into cash you can use today. A line of credit gives your business access to funds up to a set credit limit that you can draw from, repay and draw again.

Both of these options can help your business smooth out cash flow gaps, but depending on your business’s financial situation one may be a better fit than the other. If your business is waiting on customer payments and needs access to funds tied up in outstanding invoices, invoice factoring may make sense. However, if you want access to more flexible financing that allows you to do things like invest in growth, manage seasonal ups and downs or cover on-going operating expenses such as inventory, payroll or supplies, a line of credit may be a better fit.

What is invoice factoring?

Invoice factoring — also known as accounts receivable financing or accounts receivable factoring — is a financing option that lets businesses access cash based on their unpaid invoices. Unlike a line of credit, invoice factoring isn’t really a form of borrowing. Instead, you sell your invoices to a factoring company for a percentage of the invoice amount. Even if invoice factoring isn’t borrowing it can still create financial obligations for your business such as fees or potential responsibility if the invoice isn’t paid.

This can be an option if delayed customer payments are creating cash flow problems and you need working capital sooner. You’re essentially trading a portion of your invoice value in exchange for faster access to cash.

Here’s how it can work:

Sign a factoring agreement. When you sell your invoices to a factoring company you’ll need to sign an agreement outlining the terms. Be aware that factoring companies don’t work with every industry, and the agreement terms can vary.

Get advanced funding. After you’ve sold your invoices, the company will typically advance you 80% to 90% of the amount they bought them for.

Collection. The invoice factoring company will take over the responsibility of collecting the payments from your customers. Your customers will be notified when you sell the invoices.

Get the remaining balance. After the payments have been collected, the invoice factoring company will deduct their factoring fees and pay the remainder of what they owe your business.

Keep in mind that depending on the type of factoring agreement you sign, you may have to pay for any invoices they are unable to collect within a reasonable amount of time — this is called recourse factoring.

What is a business line of credit?

A business line of credit is a form of revolving credit that allows the borrower to draw funds up to a certain amount to cover expenses. It’s a flexible form of borrowing that allows you to borrow the amount you need (up to your credit limit), when you need it. As you repay, the funds will become available for you to borrow again.

A line of credit can be useful for ongoing or unpredictable business needs. It can make cash flow management easier and help ensure that you have working capital on hand when you need it.

Here’s how a line of credit can work:

Get a credit limit. If you’re approved for a line of credit by a lender, you’ll sign an agreement that outlines things such as your interest rates, payment terms and your credit limit. Your credit limit is the maximum amount you can borrow before repayment.

Take a draw. When you need funds, you can request a draw. You can typically borrow what you need by drawing just a portion, or you can draw up to your available credit limit. You’ll only pay interest on the amount you borrow.

Start repayment. As you begin to repay, the funds become available to draw again. This means you don’t have to reapply the next time you need funds. As long as you haven’t hit your credit limit, you can request more funds from your available credit.

Factoring vs. line of credit: Key differences

A line of credit and invoice factoring can both help a small business get the working capital they need, but they differ in how they allow the business to access the funds, how they’re repaid and what the financing is based on.

Pros and cons of invoice factoring.

Invoice factoring can help you get access to the cash tied up in your accounts receivable faster, so you can manage your cash flow, but it does come with some downsides. Before choosing this financing option, look closely at the fees, how customer payments will be handled and whether your business could be responsible for unpaid invoices under the agreement.

Pros of Invoice Factoring

It offers quick cash. Invoice factoring allows you to immediately access a portion of the money tied up in accounts receivable, which can help you manage cash flow problems.

It may be easier to get approved. Qualifying for invoice factoring is often easier than obtaining a bank loan. It’s not a form of borrowing, meaning you may get approved even with little to no credit history.

It’s not a traditional loan. Invoice factoring isn’t structured like a traditional business loan, so you’re not repaying borrowed funds in the same way. The money comes from your accounts receivable. If you have a recourse factoring agreement, you may have to pay for the invoices the factoring company isn’t able to collect. With non-recourse factoring, the factoring company generally takes on more of the risk if a customer doesn’t pay, though terms and protections can vary by agreement.

Cons of Invoice Factoring

Cost. Factoring fees reduce the total amount your business receives from each invoice. Depending on the factoring company, fee structure and how long it takes your customer to pay, invoice factoring may cost more than some traditional financing options.

Limited funding. The amount you can factor is limited by the value of your outstanding invoices. If your accounts receivable are low, factoring may not provide enough working capital for your needs.

Customer involvement. In many factoring agreements, the factoring company takes over the collections process and your customers may not appreciate being contacted by a third party for payment.

Pros and cons of a business line of credit.

A business line of credit can help you access fast, flexible funding. But it also comes with costs and repayment responsibilities. Before you borrow, be sure to consider how the credit limit, interest rate, fees and repayment terms could affect your cash flow.

Pros of a Business Line of Credit

Flexibility. A small business line of credit provides a revolving source of funds that can be accessed as needed. This gives you the flexibility to borrow what you need, when you need it.

Building business credit. Responsible use of a line of credit can help you build and improve your business credit score. Good credit can open the door to better financing solutions in the future.

Lower cost. The interest rates on a line of credit are typically less expensive than factoring fees. Plus, with a line of credit, you only pay interest on the amount you borrow.

Cons of a Business Line of Credit

Risk of overspending. Easy access to funds can lead to overspending and debt if a line of credit isn’t managed properly.

Qualification standards. Banks and other financial institutions will often do a credit check to evaluate your creditworthiness. Plus, they may look at financial statements and other documents in order to determine approval. While a bank line of credit can have strict standards, online lenders are often able to be more lenient.

Collateral. Some lenders may require collateral to secure a line of credit. This means the lender can seize and sell the asset if your business fails to repay the loan. However, you can find unsecured business lines of credit that don’t require collateral.

When to choose invoice factoring.

Invoice factoring can be a good choice if your business needs access to cash, has unpaid invoices and wants to avoid taking on a traditional loan. It can also be helpful for startups or businesses with limited credit history since they can be easier to qualify for.

It may not be the right fit if your business doesn’t have significant accounts receivable or if you want more control over when and how you access funds. In that case, it may be worth looking at other options.

When to choose a line of credit.

A business line of credit may be a good fit if you want flexible access to funds for ongoing or changing expenses. It gives your business more control over when to borrow, how much to draw and how to use the funds.

It may not be the right fit if you have a large, one-time expense for a specific need. In that case you may want to consider a business term loan or other financing option.

The Bottom Line

A business line of credit and invoice factoring can both help you access working capital. However, the best fit depends on several factors including your business’s needs and it’s overall financial situation. Before choosing a financing option, compare the cost, repayment structure, qualification requirements and level of control each option gives your business.