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. This article will discuss a number of considerations when making this decision.
The first question a company should consider is which financing options are available to them. Below are five key factors to consider when determining whether factoring or a business loan is a possibility.
Financials
One of the first items you should assess 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 banks do not own factoring companies 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 typically want to see two years of profitability for a potential client. Factoring companies are normally 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 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 with lower credit scores. If your credit score is in the 500s or below, you might find it tough to get either type of financing, and you should work to improve that score.
Customer Concentration
Banks and factoring companies will both be interested in how many customers you work for. If you work for only one or two customers, it will be more risky should the relationship go bad with your customer. Because factoring companies buy the invoices only for completed work, high customer concentrations can be 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 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 your options, it is time to consider how each 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 that essentially restrict 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 is typically quite a bit lower than factoring. There is a trade-off between factoring’s flexibility and cost. On the flip side, bank loans usually require origination fees and other servicing fees that some factoring companies don’t charge.
Considering these factors will help you make the best decision regarding the type of financing you need to meet your business goals as a growing oilfield service company.
