Factoring vs Line of Credit

Every business owner dreams of getting a line of credit. It’s the ultimate sign you’ve made it. You’ve proven yourself, earned the bank’s trust, and now they’ve opened the vault and handed you the keys.

Before you get caught up in the excitement, take a moment to really understand what you’re putting on the line for that shiny new line of credit. If you take the time to think it through, you might realize it’s not as fair a trade as it first seems.

Let’s start with what the bank is actually asking you to pledge as collateral. In most cases, they’ll want a blanket lien meaning everything the business owns is a part of the collateral. Here’s what a typical UCC-1 Financing Statement collateral description looks like:

Collateral Description

All assets of the Debtor, whether now owned or hereafter acquired, including but not limited to all accounts, chattel paper, deposit accounts, documents, equipment, general intangibles, goods, instruments, inventory, investment property, letter-of-credit rights, and all proceeds thereof.

This Financing Statement covers all assets of the Debtor to secure all obligations and indebtedness of Debtor to Secured Party, whether now existing or hereafter arising, including any renewals, extensions, or modifications thereof.

Now, if you take a closer look at what those assets are really worth even at liquidation value the imbalance between the loan amount and the actual asset value might surprise you.

A bank line of credit will often lend at a fraction of what those assets are truly worth, especially when it comes to highly liquid collateral like accounts receivable. It’s not unusual to see loan-to-value ratios of 40 to 60 percent on accounts receivables. In other words, for every $10,000 in open invoices, the bank might only lend $4,000 to $6,000. A great deal for the bank not so much for you.

What about your other unencumbered assets that you are pledging (real-estate, equipment, inventory, deposit accounts, vehicles) which may provide a substantial amount of other collateral. In addition, the bank will also require a personal guarantee. You can’t blame a bank, its customary and a good practice.

When you’re thinking about a line of credit that actually works for your business, there’s a simple formula worth keeping in mind. Companies with limited cash reserves should aim for a line that’s at least 2.5 times their average monthly sales. By contrast, most banks will only offer a line equal to about 10–15% of your annual sales and that’s where the problem starts for growing companies or those that need to extend payment terms.

For example, if your business does $5 million in annual sales (about $416,000 per month) and your customers take 60 days to pay, your average A/R balance would hover around $833,000. A bank might offer a line of credit between $500,000 and $750,000.

If you’re already tight on cash or reserves, or have taken a hit from bad debt, that might sound workable but it doesn’t leave much room for slower collections or new growth. And when your business is expanding, those are exactly the times when cash needs spike the most.

In the example above, a line of credit around $1.04 million based on the benchmark of 2.5 times your monthly sales gives you breathing room. It lets you manage slower customer payments without feeling the squeeze and still have the flexibility to take on new business and keep growing.

The difference between invoice factoring vs line of credit isn’t just about cost it’s about access to funding when you need it most. For many businesses, cash availability beats cost every time. Sure, a line of credit is less expensive than factoring, but if it’s not structured properly, it can actually hold your business back, especially when you have daily cash demands or are growing.

Factoring, on the other hand, typically offers the highest level of availability against your accounts receivable in some industries, up to 98.5% the same day. That kind of access gives a growing business nearly unlimited working capital to keep up with new opportunities. The same company, stuck with an undersized line of credit, can easily find itself struggling to fund growth.