Business Loans vs. Invoice Factoring for Oilfield Service Companies
Being located in the Permian Basin, our team has had the opportunity to work with oilfield service companies for the last 15 years in the Midland and Odessa areas. A question that often comes up is whether a business loan or invoice factoring makes more sense. There are a number of considerations when making this decision that we will discuss in this article.
The first question a company should consider is which financing options are available to them. Below are 5 key factors in determining if factoring or a business loan is a possibility.
Financials
One of the first items you should assess is what is the current condition of your financial statements. Banks typically have pretty strict requirements on the quality of financial statements they need to see. Because factoring companies are not owned by banks and because their rates are higher, they are typically more flexible when it comes to the quality of the financial statements.
Length of Profitability
Banks will typically want to see 2 years of profitability for a potential client. Factoring companies are typically much more lenient here and are willing to work with startups. This is possible because the factoring company’s main credit risk is to the customer that you are working for.
Credit Score of Owners
While both banks and factoring companies will look to the credit of owners to determine the risk of a deal, factoring companies are often able to work with owners who have lower credit scores. If your credit score is below 500, that might make it tough for you to get either type of financing and you should work to try to improve that score.
Customer Concentration
Banks and factoring companies will both be interested in how many customers you are working for. If you are only working for one or two customers, that will make it more risky should the relationship go bad with your customer. Because factoring companies buy the invoices only for completed work, this can make high customer concentrations more manageable for a factoring company.
Oil and Gas Appetite
In the last decade, many banks have tried to reduce their exposure to oil and gas and, in particular, oilfield service companies. Banks have a tough time with the ups and downs in the oil and gas industry, although there are certainly some banks that are allowed to do some amount of oil and gas deals. Factoring companies on the other hand are typically more comfortable with oilfield service and there are some factoring companies located mainly in West Texas that focus primarily on this type of business.
Once you have determined what options are available to you, it is time to consider how each different financing option fits with your business goals.
Below are three key items to consider.
Leverage
Business loans add debt to your company, also known as leverage. Along with leverage comes the risk that you could lose your company if you fall upon bad times or breach financial covenants (more below). Invoice Factoring involves selling your invoices to a factoring company rather than taking on debt, so as long as your customers pay you don’t have these same concerns. Should you choose to take on a business loan, make sure you have looked at downside scenarios and feel comfortable that you will be able to keep your business in a downturn.
Covenants / Flexibility
Business loans will typically contain covenants which are essentially restrictions on how you can operate your business. A typical covenant is the interest coverage ratio which requires that you make enough cash flow to cover your interest payment plus some cushion. There are often also covenants that require approval for items like making a change to a senior officer in your company. Factoring typically doesn’t require these types of covenants.
Pricing
Pricing for business loans are typically quite a bit lower than factoring. There is a trade off between the flexibility that factoring provides and the cost. On the flip side, bank loans typically require origination fees and other servicing fees that some factoring companies don’t charge.
Taking these factors into account will help you make the best decision for the type of financing you need to meet your business goals as a growing oilfield service company.
