Types of Small Business Financing Options

types of small business financing options

Wondering the difference between the types of small business financing options? Getting the right financial product for your small business is important. However, entrepreneurs should be careful about which small business financing options they choose.

Here’s a summary of the main types of small business financing:

  • Merchant Cash Advance: Offers quick access to capital based on future credit card sales. Ideal for businesses with high credit card transaction volumes, providing funds without the need for collateral, but typically comes with higher costs.
  • Invoice Factoring: Allows businesses to sell their outstanding invoices at a discount to a factoring company. It’s a way to get immediate cash flow relief, suitable for businesses with long invoice payment terms.
  • Small Business Loan: Traditional loans provided by banks or financial institutions, often used for long-term investments, expansion, or purchasing equipment. Requires a good credit score and may use business assets as collateral.
  • Line of Credit: Provides businesses with a revolving credit limit they can draw against as needed, only paying interest on the amount used. Offers flexibility and is ideal for managing cash flow and unexpected expenses.
  • Purchase Order Financing: Offers funding based on confirmed purchase orders before delivery. Suitable for businesses needing capital to fulfill large orders, helping to cover supplier costs without depleting cash reserves.

Some make more sense for your company than others. Small Business Trends talked with Hanna Kassis an expert at Segway Financial about how to differentiate between loans, cash advances and small business factoring.

Though sometimes called an invoice advance loan, the name is incorrect.

“The biggest difference is cash advances and factoring are not loans, although sometimes they’re disguised as loans,” Kassis says. The trick for small business owners is in understanding how to pick the financial product that works to make their situation better.  Choosing the wrong path can lead to deeper financial issues if your small business is in some trouble to begin with.

Here’s a chart showing the benefits of  the various types of financing depending upon your business needs:

Types of Small Business Financing Options

types of small business financing

When looking at the options for financing your small businesses, perhaps the most important thing to learn is the difference between loans and advances. How do these two forms of financing compare and which is best for your business.

The Difference Between Loans and Advances

types of small business financing options

There are some fundamental differences. For example, small business loans report to the credit bureaus about the credit of the business and not the owners. These are generally the way to go when you’re looking to make a long term investment in your business.

A good FICO score is required. All your company assets can be used as collateral and funding usually takes about 3-7 days. Use these when you’re on a stable footing financially and looking to grow or expand. Small business loans are a great way to replace outdated machinery and even build a new wing.

Miss a payment on one of these and it gets reported on your business credit. With the other two types, that kind of slip up gets reported on your personal credit.

Merchant Cash Advances and Small Business Factoring: For a Different Set of Needs

These other products have a different set of requirements. A merchant cash advance is a good product for an emergency financial situation. Factoring is the right tool to match income and expenses. With the merchant cash advance, cash flow history is required but your small business doesn’t need to supply any collateral.

Small business factoring, on the other hand, requires actual invoices and those receivables and invoices are used as collateral. Hence the reason this is sometimes called an invoice advance loan.

Kassis notes another difference between the two products.

“Companies that qualify for factoring are typically B2B under unfavourable terms,” He says. “That delayed payment could be a result of the seller offering it to get business or the vendor offering it because they’re spending enough money they can dictate the terms of the deal.”

Say you’re selling bolts to a manufacturer. They’re buying in volume and keeping you busy, but not paying for terms of 30, 60 or 90 days.  Factoring allows you to use an invoice advance loan to help you over temporary cash crunches. Products like the invoice advance loan generally take about 2-5 days to process.

Sending Invoices

types of small business financing options

If you send invoices, you have a wider range of options. Those choices are limited for businesses like grocery stores if they accept cash up front.

“Businesses with invoices will qualify for factoring, cash advances or a loan,” Kassis says. “Businesses that don’t invoice can only get a cash advance or a loan.”

So here’s a bit more merchant cash advance info to consider.

Cash advances are the quickest solution to get but you need to be careful when you make a decision to go after one of these. There is no collateral needed here and the time to fund is quick at 1-3 days. However, Kassis is clear small businesses need to take a good look at why they’d need this type of money before they act.

“The cash advance is the catch-all. With about $10,000 a month from any source, you can probably get one of these products.”

Cash Advance Catch-all

types of small business financing options

However, there’s a big caveat to this catch-all. Kassis explains this is a great product for seasonal businesses and restaurants in tourist areas. Both of these small businesses might need some cash ahead of their busy season.  He’s clear, however, a cash advance won’t stop a downward business slide.

“If you’re struggling, a cash advance will put you out of business,” he says.

In conclusion, understand what kind of financing you’re looking for when examining the different options. In particular, know the difference between loans and advances and which is right for your business.

So What About the Invoice Advance Loan?

The invoice advance loan, despite its name, isn’t actually a traditional loan. It’s an advance based on the projected earnings a business expects from its invoices.

This financing option allows businesses to access immediate capital based on their invoice’s value, helping them navigate cash flow challenges without waiting for the typical 30, 60, or 90-day payment terms.

While traditional loans typically rely on creditworthiness and might require collateral, invoice advances focus primarily on the reliability of a company’s clients and the anticipated revenue.

They are especially beneficial for businesses that operate in industries with extended payment cycles, where delays in payment can cripple operations.

However, like all small business funding options, it’s essential to consider the associated costs and terms. While invoice advances can be quicker and more flexible than traditional loans, they might also come at a higher cost.

Therefore, businesses must assess their immediate liquidity needs against the costs of this financing option.

In essence, the invoice advance loan offers a valuable solution for businesses in need of quick capital. But it’s crucial to be fully aware of its intricacies before diving in. This will ensure that the chosen financing tool aligns with the company’s financial health and long-term goals.

Choosing a Small Business Financing Option

types of small business financing options

Choosing the right financing option for your small business can feel like navigating a complex maze. With so many choices available, it’s crucial to select one that aligns with your company’s needs, goals, and financial health. Here are five essential considerations to guide your decision:

  • Assess Your Financial Health: Before diving into any financing option, evaluate your business’s financial statements. Understand your revenue, expenses, and existing debts. A strong financial standing may allow you more flexibility in terms of loan terms and interest rates.
  • Determine the Purpose: Clearly define why you need the financing. Is it for expansion, purchasing inventory, bridging a cash-flow gap, or maybe acquiring new machinery? The purpose will guide you towards the most suitable financing option.
  • Understand the Costs: Beyond just the principal amount and interest, delve into all associated costs of the financing option. This includes origination fees, processing charges, potential penalties, and any other hidden costs.
  • Flexibility and Terms: Not all financing options have the same repayment terms. Some might require monthly repayments while others might have more flexible schedules. Choose an option that aligns with your projected cash flow to avoid future financial strain.
  • Consider the Speed of Funding: In some cases, you might need funds urgently. Options like merchant cash advances or invoice financing can be quicker than traditional bank loans. Determine how fast you need the funds and choose an option that can meet that timeline.

Navigating The Types of Small Business Financing Options

Understanding the nuanced differences between loans, cash advances, and factoring is crucial for small business owners exploring financing options. Each method serves distinct needs, from long-term investments and emergency financial situations to managing cash flow challenges due to delayed payments.

The choice between these financing options should be informed by a thorough assessment of your business’s financial health, the specific purpose for seeking funds, and an understanding of the potential impact on both your business and personal credit.

Loans offer a structured financing solution with the potential for growth and expansion, requiring a good credit score and often using company assets as collateral. They are best suited for businesses on stable financial ground looking to make significant investments in their future.

Merchant cash advances provide quick, collateral-free funds, making them ideal for immediate financial needs or seasonal businesses anticipating a revenue spike. However, their ease of access should be weighed carefully against the cost and the potential for negative impacts if used as a stopgap for ongoing financial issues.

Factoring, or invoice advance loans, offers a flexible financing solution that turns unpaid invoices into immediate capital, ideal for businesses with long payment cycles. This option emphasizes the creditworthiness of your clients and the strength of your receivables, offering a lifeline to maintain operations and cash flow without the need for traditional collateral.

When choosing a financing option, it’s essential to:

  • Assess the financial health and stability of your business.
  • Clearly identify the financing need and how it aligns with your business goals.
  • Understand the full cost of financing, including interest rates and any additional fees.
  • Consider the flexibility of repayment terms and how they fit with your cash flow.
  • Evaluate the speed of funding and how it meets your immediate financial needs.

Navigating the landscape of small business financing requires a strategic approach, informed by an understanding of the different options available and a clear vision of your business’s needs and goals.

By carefully considering the type of financing that best suits your situation, you can secure the necessary funds to support your business’s growth and stability, ensuring a prosperous future.

Factoring Photo via Shutterstock
Chart courtesy of InvoiceFinancing.net

Rob Starr Rob Starr is a staff writer for Small Business Trends and has been a member of the team for 7 years. He is a graduate of Ryerson University in Toronto with a Bachelor of Journalism degree. His print credentials include employment with various Toronto area newspapers and three works of fiction: The Apple Lady (2004), Creekwater (2006) and Sophistry By Degrees (2008) published by Stonegarden Press In California.