Consider a business that sells to other businesses. Most of the time, they’ll take a purchase order from their customer and agree on a quote for the work, then send a sales invoice to the customer once the work is completed.

Payment terms for these invoices could be 28 days for some, but as much as 120 days for others — taking even longer if the customer doesn’t pay on time.

In other words, there’s a big cash flow gap between spending money to complete a project, and receiving payment for it.

How does factoring work?

Invoice finance (of which factoring is one variation) aims to solve this problem. As soon as the invoice is raised, you send it to the invoice finance provider, who will advance most of the value immediately (up to 90%). When your customer pays, you get the remainder of the invoice value minus the lender’s fees.

Factoring is a subcategory of invoice finance, and works under the same principle, but with some important differences. Firstly, unlike other types of invoice finance, the factoring provider (or ‘factor’) will take over collections. That means they will chase your invoices for you, dealing directly with your customers. This is known as a credit control service.

Secondly, factoring is usually applied to the entire sales ledger. That means you’ll get a cash advance on all of your outstanding invoices, rather than for one project or customer (there are other types of invoice finance available for the latter).

Finally, because the factor has a high degree of control, factoring is normally the product lenders favour for smaller or less established businesses.

What factoring companies are there?

There are lots of factoring companies on the market these days — ranging from small local providers with a few dozen clients, to larger providers with thousands of factoring customers around the country.

General speaking, it’s more difficult to secure factoring with a major bank, but the costs are typically low and the banks are highly regulated.

Challenger banks and independent specialists, on the other hand, are looking to break the stranglehold of traditional high street banks, offering competitive rates and a strong appetite to do business.

There are also niche sector specialists and smaller providers offering factoring to firms local to them, or firms in a particular sector. With these smaller specialists, access to senior decision-makers can make all the difference.

Who can benefit from factoring?

Credit control services are included with factoring, and smaller businesses without financial controllers often appreciate this, because payment collections are one less thing to worry about. On the other hand, it’s important to remember that your customers will know you’re using a factoring provider. For many companies this won’t be an issue, but others will prefer confidential finance facilities.

Factoring is designed for smaller businesses that issue invoices — if you don’t trade on credit or only take a small portion of your sales via invoices, you probably can’t get factoring.

Conclusion

Overall, factoring can be a great fit for fast-growing companies that want to speed up the cashflow cycle, and focus on the next job with extra working capital at their disposal.

However, if you’re not eligible for factoring there are many other revenue-based products in alternative finance that could help, such as merchant cash advances which use card terminals, and revenue loans that are based on your recent accounts.

So there you have it — that’s invoice factoring.

Conrad Ford is chief executive of Funding Options, recently described by the Telegraph as “the matchmaking website for small businesses and lenders”.

Related: Factoring for fast cash solutions