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Debt Financing or Off Balance Sheet Financing?
In this article, we will discuss two types of financing: Debt Financing and Off Balance Sheet Financing.
Debt Financing describes a traditional or conventional loan issued to a business that creates a liability on the balance sheet. Due to the nature of this type of financing, it affects debt-to-income ratios that are usually considered when applying for future loans or gaining access to capital.
Off-Balance Sheet Financing has no affect (as the title implies) on the Balance Sheet. There are two types: Equipment Leasing and Factoring.
Equipment Leasing allows a business to buy equipment with rental payments, and the balance sheet is not affected with debt-to-income ratios that may defer future access to capital. (You may want to ask your accountant if Equipment Leasing is the right choice for your business). The key point is this: There is no reason to tie up your working capital when you can rent to own the equipment. Even if the cost of the funds is higher than a traditional loan, the rent payment to the leasing company is 100% tax deductible, and sometimes, that alone may offset some of the additional cost.
Another type of Off-Balance Sheet Financing is “Factoring” (Accounts Receivable Financing). Factoring is the purchase of a company's accounts receivable. The factoring company converts the accounts receivable to cash and leaves the business with cash on hand and no receivables. Factoring is not a loan, so there is nothing to pay back. See Factoring (below) for more information on how it works.
Who uses Factoring?
Business owners who face exponential growth can find themselves short of the cash they need to meet everyday operating expenses. Many business owners (during their first financing stage) never anticipate accelerated growth. Small businesses can access capital by tapping into a personal savings account, using credit cards or taking out a home equity loan but they may fall short of cash when uneven sales patterns occur.
Fluctuating sales can interrupt the working capital needed for supplies, rent, payroll and routine expenses. This is a common scenario that is usually not anticipated in the financial planning of the business. When business growth outpaces working capital, few options are available.
Business owners, who frantically seek financing, normally go to the most obvious source: Banks (that offer Debt Financing). They may hit a brick wall after they visit 20 banks and realize that the maximum amount of their loan can only match the collateral that their business has to offer. Most start-up businesses do not have enough assets or equity to meet the loan requirements. In addition, conventional loans are very slow in processing and may not be approved in time to meet current obligations.
Factoring (Off-Balance Sheet Financing) is available for fast growing businesses that offer credit terms to their customers or commercial accounts. It is the easiest and most flexible type of financing available. It involves establishing a credit line by advancing money to a business by pledging its accounts receivable as collateral. The invoice created by the business (for services or products accepted by a customer) is considered (by the factoring company offering funding) to be a realized asset.
How does factoring work?
A business issues an invoice (receivable) to its customer. The factoring company purchases the receivable (from the business) at a discount. The factoring company then transfers funds to the business and mails the original invoice to the customer. Then the factoring company waits to get paid. It is that simple! The process to set up takes about 5 to 7 working days and the business owners do not need good credit scores for approval. Factoring companies rely mainly on the credit worthiness of the customer because the invoice for delivered product or service is the collateral used to fund, not your credit score or financial statements.
How much does factoring cost?
Factoring companies charge discount fees based on the value of the invoice. If your business accepts credit cards, then you are already factoring to a degree. For example, your credit card merchant charges you a discount fee of 3% and you receive 97%. A factoring company works almost the same way but the advance and discount fees may vary depending on volume and industry.
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