UNIT 3

Factoring

3.1 Factoring: concept, nature and scope of Factoring

Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount.

Factoring provides resources to finance receivables. It also facilitates the collection of receivables. The word factor is derived from the Latin word facere. It means to make or do or to get things done. Factoring simply refers to selling the receivables by a firm to another party. The buyer of the receivables is called the factor.

According to this agreement the factor undertakes the receivables, the credit, the collection task, and the risk of bad debt. The firm selling its receivables (client) receives the value of the receivables minus a commission charge as compensation for the risks the factor assumes. Thereafter, customers make direct payments to the factor. In some cases receivables are sold to factor at a discount. In this case factor does not get commission.

According to this arrangement, customers make direct payment to the client. It should be noted that both factoring and securitisation provide financing source for receivables. In factoring, the financing source is the factor. But in securitisation, the public (investors) who buys the securities is the factoring source.

Parties to the Factoring

There are basically three parties involved in a factoring transaction.

1. The buyer of the goods.
2. The seller of the goods
3. The factor i.e. financial institution.

The three parties interact with each other during the purchase/ sale of goods.

The Buyer

1. The buyer enters into an agreement with the seller and negotiates the terms and conditions for the purchase of goods on credit.
2. He takes the delivery of goods along with the invoice bill and instructions from the seller to make payment to the factor on due date.
3. Buyer will make the payment to the factor in time or ask for extension of time. In case of default in payment on due date, he faces legal action at the hands of factor.

The Seller

1. The seller enters into contract for the sale of goods on credit as per the purchase order sent by the buyer stating various terms and conditions.
2. Sells goods to the buyer as per the contract.
3. Sends copies of invoice, delivery challan along with the goods to the buyer and gives instructions to the buyer to make payment on due date.
4. The seller sells the receivables received from the buyer to a factor and receives 80% or more payment in advance.
5. The seller receives the balance payment from the factor after paying the service charges.

The Factor

1. The factor enters into an agreement with the seller for rendering factor services i.e. collection of receivables/debts.
2. The factor pays 80% or more of the amount of receivables copies of sale documents.
3. The factor receives payments from the buyer on due dates and pays the balance money to the seller after deducting the service charges.
   

Nature and scope

Factoring is a tool of receivable management employed to release funds tied up in credit extended to customers.

1. Factoring is a service of financial nature involving the conversion of credit bills into cash. Accounts receivables, bills recoverable and other credit dues resulting from credit sales appear in the books of account as book credits.

2.   The risk associated with credit are taken over by the factor which purchases these credit receivables without recourse and collects them when due.

3.   A factor performs at least two of the following functions: i. Provides finance for the supplier including loans and advance payments. Ii. Maintains accounts, ledgers relating to receivables. Iii. Collects receivables. Iv. Protects risk of default in payments by debtors.

4.   A factor is a financial institution which offers services relating to management and financing of debts arising out of credit sales. It acts as another financial intermediary between the buyer and seller.

5.   Unlike a bank, a factor specialises in handling and collecting receivables in an efficient manner. Payments are received by the factor directly since the invoices are assigned in favor of the factor

6.   Factor is responsible for sales accounting, debt collection and credit control protection from bad debts, and rendering of advisory services to their clients.

7.   Factoring is a tool of receivables management employed to release funds tied up in credit extended to customers and to solve the problems relating to collection, delays and defaults of the receivables.

8.   Usually the period for factoring is 90 to 150 days. Some factoring companies allow even more than 150 days.

9.   Factoring is considered to be a costly source of finance compared to other sources of short term borrowings

10.   Factoring receivables is an ideal financial solution for new and emerging firms without strong financials. This is because credit worthiness is evaluated based on the financial strength of the customer (debtor). Hence these companies can leverage on the financial strength of their customers.

11.   Bad debts will not be considered for factoring.

12.   Credit rating is not mandatory. But the factoring companies usually carry out credit risk analysis before entering into the agreement.

13.   Factoring is a method of off balance sheet financing

14.   Cost of factoring=finance cost + operating cost. Factoring cost vary according to the transaction size, financial strength of the customer etc. The cost of factoring vary from 1.5% to 3% per month depending upon the financial strength of the client's customer.

15.   Indian firms offer factoring for invoices as low as 1000Rs

16.   For delayed payments beyond the approved credit period, penal charge of around 1-2% per month over and above the normal cost is charged (it varies like 1% for the first month and 2% afterwards)

Key takeaways –

1. Factoring is a financial option for the management of receivables. In simple definition it is the conversion of credit sales into cash. In factoring, a financial institution (factor) buys the accounts receivable of a company (Client) and pays up to 80%(rarely up to 90%) of the amount immediately on agreement

3.2 Forms of Factoring

There are different types of factoring. These may be briefly discussed as follows:

1. Recourse and Non-recourse Factoring

In a recourse factoring arrangement, the factor has recourse to the client (selling firm) if the receivables purchased turn out to be bad, Let the risk of bad debts is to be borne by the client and the factor does not assume credit risks associated with the receivables. Thus the factor acts as an agent for collection of bills and does not cover the risk of customer’s failure to pay debt or interest on it. The factor has a right to recover the funds from the seller client in case of such defaults as the seller takes the risk of credit and creditworthiness of buyer. The factor charges the selling firm for maintaining the sales ledger and debt collection services and also charges interest on the amount drawn by the client (selling firm) for the period.

Whereas, in case of non-recourse factoring, the risk or loss on account of non-payment by the customers of the client is to be borne by the factor and he cannot claim this amount from the selling firm. Since the factor bears the risk of non-payment, commission or fees charged for the services in case of nonrecourse factoring is higher than under the recourse factoring. The additional fee charged by the factor for bearing the risk of bad debts/non-payment on maturity is called del credere commission.

2.   Advance and Maturity Factoring -  Under advance factoring arrangement, the factor pays only a certain percentage (between 75 % to 90 %) of the receivables in advance to the client, the balance being paid on the guaranteed payment date. As soon as factored receivables are approved, the advance amount is made available to the client by the factor. The factor charges discount/interest on the advance payment from the date of such payment to the date of actual collection of receivables by the factor. The rate of discount/interest is determined on the basis of the creditworthiness of the client, volume of sales and prevailing short-term rate. Sometimes, banks also participate in factoring transactions. A bank agrees to provide an advance to the client to finance a part say 50% of the (factored receivables - advance given by the factor)

In case of maturity factoring, no advance is paid to client and the payment is made to the client only on collection of receivables or the guaranteed payment data as the case may be agreed between the parties. Thus, maturity factoring consists of the sale of accounts receivables to a factor with no payment of advance funds at the time of sale.

3.   Conventional or Full Factoring - Under this system the factor performs almost all services of collection of receivables, maintenance of sales ledger, credit collection, credit control and credit insurance. The factor also fixes up a draw limit based on the bills outstanding maturity wise and takes the corresponding risk of default or credit risk and the factor will have claims on the debtor as also the client creditor. It is also known as Old Line Factoring. Number of other variety of services such as maturity-wise bills collection, maintenance of accounts, advance granting of limits to a limited discounting of invoices on a selective basis are provided. In advanced countries, all these methods are popular but in India only a beginning has been made. Factoring agencies like SBI Factors are doing full factoring for good companies with recourse.

4.   Domestic and Export Factoring - The basic difference between the domestic and export factoring is on account of the number of parties involved. In the domestic factoring three parties are involved, namely: The import factor acts as a link between export factor and the importer helps in solving the problem of legal formalities and of language.

1. Customer (buyer)

2. Client (seller)

3. Factor (financial intermediary)

All the three parties reside in the same country. Export factoring is also termed as cross-border/international factoring and is almost similar to domestic factoring except that there are four parties to the factoring transaction. Namely, the exporter (selling firm or client), the importer or the customer, the export factor and the import factor. Since, two factors are involved in the export factoring, it is also called two-factor system of factoring. Two factor system results in two separate but inter-related contracts:

1. Between the exporter (client) and the export factor.

2. Export factor and import factor.

The import factor acts as a link between export factor and the importer helps in solving the problem of legal formalities and of language. He also assumes customer trade credit risk, and agrees to collect receivables and transfer funds to the export factor in the currency of the invoice. Export/International factoring provides a non-recourse factoring deal. The exporter has 100 % protection against bad debts loss arising on account of credit sales.

5.   Limited factoring - Under limited factoring, the factor discounts only certain invoices on selective basis and converts credit bills into cash in respect of those bills only

6.   Selected Seller Based Factoring - The seller sells all his accounts receivables to the factor along with invoice delivery challans, contracts etc. after invoicing the customers. The factor performs all functions of maintaining the accounts, collecting the debts, sending reminders to the buyers and do all consequential and incidental functions for the seller. The sellers are normally approved by the factor before entering into factoring agreement.

7.   Selected Buyer Based Factoring - The factor first of all selects the buyers on the basis of their goodwill and creditworthiness and prepares an approved list of them. The approved buyers of a company approach the factor for discounting their purchases of bills receivables drawn in the favour of the company in question (i.e. seller). The factor discounts the bills without recourse to seller and makes the payment to the seller.

8.   Disclosed and undisclosed factoring - In disclosed factoring, the name of the factor is mentioned in the invoice by the supplier telling the buyer to make payment to the factor on due date. However, the supplier may continue to bear the risk of bad debts (i.e. non-payments) without passing to the factor. The factor assumes the risk only under nonrecourse factoring agreements. Generally, the factor lays down a limit within which it will work as a non-recourse. Beyond this limit the dealings are done on recourse basis i.e. the seller bears the risk. Under undisclosed factoring, the name of the factor is not disclosed in the invoice. But still the control lies with the factor. The factor maintain sales ledger of the seller of goods, provides short-term finance against the sales invoices but the entire transactions take place in the name of the supplier company (seller).

3.3 Factoring vis-à-vis Bills Discounting

Factoring

Factoring is a financial option for the management of receivables. In simple definition it is the conversion of credit sales into cash. In factoring, a financial institution (factor) buys the accounts receivable of a company (Client) and pays up to 80%(rarely up to 90%) of the amount immediately on agreement. Factoring company pays the remaining amount (Balance 20%-finance cost-operating cost) to the client when the customer pays the debt. Collection of debt from the customer is done either by the factor or the client depending upon the type of factoring.

Bills discounting

When goods are sold on credit, the receivables or book debts are created. The supplier or seller of goods draws a bill of exchange on the buyer or debtor for the invoice price of the goods sold on credit. It is drawn for a short period of 3 to 6 months. Sometimes it is drawn for 9 months. After drawing the bill, the seller hands over the bill to the buyer. The buyer accepts the same

Similarities: Factoring is somewhat similar to bills discounting in the sense that both these services provide short term finance. Again discount account receivables which the client would have otherwise received from the buyer at the end of the credit period.

Difference

3.4 Factoring vis-à-vis credit Insurance Factoring vis-à-vis Forfeiting

Factors Vs Credit Insurance:

Credit insurance is a way to provide your business with protection against the failure of a customer to pay their trade credit debts.

The principle difference between Credit Insurance vs. Factoring is that with Credit Insurance you are insuring your A/R, with Factoring you are selling your A/R. Both involve forms of risk mitigation, shifting the credit, collections and financing responsibilities outside of the company, but in very different ways. Consider too, often with Factors once a receivable is considered uncollectable, the risk is transferred back to the business who sold it. Credit Insurance indemnifies the loss, guaranteeing payment for approved buyers within the terms of the policy, regardless of whether that A/R is ever collected.

Factoring vis-à-vis Forfeiting

Forfeiting

The term ‘forfait’ is a French world. It means ‘to surrender something’ or ‘give up one’s right’. Thus forfaiting means giving up the right of exporter to the forfaitor to receive payment in future from the importer. It is a method of trade financing that allows exporters to get immediate cash and relieve from all risks by selling their receivables (amount due from the importer) on a ‘without recource’ basis. This means that in case the importer makes a default the forfaitor cannot go back to the exporter to recover the money.

Key takeaways –

1. Credit insurance is a way to provide your business with protection against the failure of a customer to pay their trade credit debts
2. Forfaiting means giving up the right of exporter to the forfaitor to receive payment in future from the importer.

Sources

1. M.Y.Khan, Financial Services, Tata McGraw-Hill, 11th Edition, 2008

2. Gopal C.R – Management Financial Service – S.Chand

3. NaliniPravaTripathy, Financial Services, PHI Learning, 2008

4. Machiraju, Indian Financial System, Vikas Publishing House, 2nd Edition, 2002.

5. J.C.Verma, A Manual of Merchant Banking, Bharath Publishing House, New Delhi.