Factoring and invoice discounting are both forms of receivables finance that allow you to raise money directly against your outstanding debtors as a way of covering a 'funding gap' and this is intended as an introduction to what they are and how they work.

The easiest way to illustrate how this funding gap arises, and how these forms of 'debtor based' finance can fit in, is by way of looking at a couple of typical business situations in both a service sector and a manufacturing business.

Why Your Business Needs Cash - The Funding Gap

Imagine, for example, that you run an agency supplying temporary workers that you place with a customer for two weeks at a time.

At the end of the fortnight your staff will want to be paid (let's say they cost £500) and you will be able to raise an invoice to the client for their time (let's say for £1,000, ignoring VAT). The only problem is that in reality your customer is not going to pay immediately but will typically take say eight weeks to settle your bill.

This leaves you with a gap between the time when you have to pay your workers their £500 and the time when you receive the cash from your customers for the job and this 'funding gap' has to be filled from somewhere; either from cash invested into the business by you as share capital; or directors' loans; or by leaving undistributed profits in the business; or by borrowing.

The same issue arise in manufacturing businesses which will normally receive a period of credit from their raw material suppliers (let's say that on average you can take eight weeks to pay).

However, you could be holding on average say 21 days worth of raw material stocks, 14 days of work in progress and 21 days worth of finished goods stock. This means that by the time you actually come to sell the goods which the purchases have been used to make, you are due to pay your supplier.

But you will suffer from the same problem as the temporary labour agency as you are also likely to be selling on credit. So, once again it will be say eight weeks before you receive the cash in from your customers, which will give you a similar funding gap.

Obviously you can look to manage your 'working capital requirement' to minimise this gap and therefore your funding needs. You could, for example, try to keep your investment in raw material, work in progress and finished goods stocks to the minimum practical level that your business can manage with; while also being as efficient as possible at collecting in payment from your customers to minimise the cash tied up in debtors.

Overtrading And The Advantage Of Flexible Funding

Looking at your business's finances from this point of view shows why having sufficient flexible funding is so vital for growing businesses as it shows how and why access to cash is needed to support any given level of your business's trading. From this you can also hopefully see that if your business's level of trading increases, then the level of funding it will need will increase to match.

However most bank facilities are relatively inflexible as they are set at a particular level for a period of say a year; are usually based on an assessment of a business's funding requirements and available security at the time they were agreed (which will generally be based on say 50% of your 'current' debtors); and can therefore be inflexible in comparison to the rapidly changing requirements that can occur in a high growth business.

Businesses which expand faster than the level that their access to cash can support, a problem known as 'overtrading', often fail, as while they are trading profitably, they simply run out of cash to pay their suppliers.

Since the funding available through debtor based finance is based on your sales and debtors, it is therefore an ideal way for high growth businesses to avoid this problem. As your level of turnover, and as a result, the value of your outstanding debtors grow, debtor based finance automatically provides you with access to more cash to match.

So it is important to ensure that your business not only has sufficient cash available for its present needs, but has sufficiently flexible facilities to meet its future needs as it grows.

Author Mark Blayney is a business finance raiser and author. For more information on factoring or invoice discounting or any aspect of finance for owner managed businesses contact him at www.business-loans-info.co.uk