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MODULE – 2.9

FACTORING

Introduction:

We know Receivables constitute a significant portion of current assets of a firm. But, for

investment in receivables, a firm has to incur certain costs such as costs of financing

receivables and costs of collection from receivables. Further, there is a risk of bad debts also.

It is, therefore, very essential to have a proper control and management of receivables. In fact,

maintaining of receivables poses two types of problems;

(i) the problem of raising funds to finance the receivables, and

(ii) the problems relating to collection, delays and defaults of the receivables.

A small firm' may handle the problem of receivables management of its own, but it

may not be possible for a large firm to do so efficiently as it may be exposed to the

risk of more and more bad debts. In such a case, a firm may avail the services of

specialized institutions engaged in receivables management, called factoring firms.

Reasons for Factoring

There are a significant number of reasons why companies should consider accounts

receivable factoring.

1. Factoring is a swift way for companies to raise money. A factoring deal can be done in

as little as 24 hours. This can be extremely beneficial for a company that needs

immediate working capital, or that is looking to expand their operations quickly.

2. Factoring shortens the collections process Businesses sometimes have to wait for weeks or even months before they are paid for services

rendered. During this time, they might be cash poor and may not have the funds available to grow their

businesses or even pay for current operational expenses. Accounts receivable factoring remedies late-

paying clients.

3. Debt can be a useful tool to build and sustain a business. However, it can also be risky,

especially for new companies. Factoring allows companies to receive badly needed capital

without relying on an expensive loan.

4. Getting a business loan has always been challenging. Today, it is even tougher because banks

are holding on tighter than ever to their money. If a company has not been in business very

long or has had problems repaying loans in the past, the likelihood they will receive a bank

loan is small. In this case, a good alternative would be for a company to use factoring

services.

5. For small businesses that don’t have a collection department or adequate personnel, a

factoring company can provide a much-needed service. Factoring can provide them

with what they need (money) to survive and expand by advancing money for their

invoices and then collecting on them. The seller will have to pay for these services,

but it is well worth it for many businesses

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Evolution of Factoring

Factor has its origin from the Latin word ‘Facere’ meaning to get things done. The dictionary

defines a factor as an agent particularly a mercantile agent. Factoring has a long fascinating

history which traces back through several centuries. In the early stages factors were itinerant

merchants who were entrusted with merchandise belonging to others.

• Factoring is a fund based financial service, provides resources to finance receivables as well as facilitates the collection of receivables.

• Factoring means an arrangement between a factor and his client which includes at least two of the following services to be provided by the factor

• 1. Finance • 2. Maintenance of accounts • 3. Collection of debts and • 4. Protection against credit risk

Factoring has being introduced with the Recommendation of Kalyansundaram

Committee.

Kalyansundaram committee was appointed in 1989 by RBI to study the feasibility of introducing factoring service in India. Accordingly in 1990 the recommendation of the committee were accepted, these are:-

There is more scope for introducing factoring in India, especially through banks.

Exporters can enjoy more benefits by factoring services.

The growth of factoring will be so fast that within 2 or 3 years, it will be a viable business.

Export factors can provide various other services also.

All the industries as well as service can avail factoring service.

Bank can take up factoring business due to their excellent network of branches

Banking Regulation Act, 1949, was amended in 1991 for Banks setting up factoring services.

SBI/ Canara Bank have set up their Factoring subsidiaries

SBI Factors Ltd, Canara Bank Factors Ltd

RBI has permitted Banks to undertake factoring services through subsidiaries.

What is Factoring?

Factoring is a sale of Book Debts by a firm (client) to a financial institution (factor) on the understating that the Factor will pay for the Book debts as and when they are collected or on a guaranteed payment date. Normally, the Factor makes a part payment (usually up to 80%) immediately after the debts are purchased thereby providing immediate liquidity to the client. The financial institution (factor) undertakes the risk. For this type of service as well as for the interest, the factor charges a fee for the intervening period. This fee or charge is called factorage.

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Definition

Factoring is defined as a continuing legal relationship between a financial institution ( the factor) and a business concern ( the client) , selling goods or providing services to trade customers( the customers) on open account basis whereby the Factor purchases the client’s book debts( accounts receivables) either with or without recourse( recourse risk with client, non-recourse risk with factor) to the client and in relation thereto controls the credit extended to customers and administers the sales ledgers”.

Thus Factor is a 1. Financial intermediary, 2. It buys invoices of a manufacturer or a trader at a discount and 3. Takes responsibility for collection of payments. The parties involved in the factoring transaction are a. Supplier or seller (client) b. Buyer or debtor (customer) and c. Financial intermediary (Factor)

The common terminology used in a factoring transaction are as follows:

(i) Client: He is also known as supplier. It may be a business institution supplying the goods/services on credit and availing of the factoring arrangements.

(ii) Customer: A person or business organisation to whom the goods/ services have been supplied on credit. He may also be called as debtor.

(iii) Account receivables: Any trade debt arising from the sale of goods/ services by the client to the customer on credit.

(iv) Open account sales: Where in an arrangement goods/services are sold/supplied by the client to the customer on credit without raising any bill of exchange or promissory note.

(v) Eligible debt: Debts, which are approved by the factor for making prepayment. (vi) Retention: Margin maintained by the factor. (vii) Prepayment: An advance payment made by the factor to the client up to a certain

percent of the eligible debts.

Why use Factoring? 1. Through the use of Factoring receivables are instantly converted into cash leading to

improved cash flows that can help funding of future growth. 2. It facilitate an efficient follow up of payments from buyers, which is made possible

through relationships developed by factors with client’s buyers. 3. Factoring provides credit protection for export sales which enables to do business with

buyer who are unwilling to open Letters of Credit. 4. Factoring also provides other peripheral services such as advisory services, credit

assessment etc.

Mechanics of Factoring

1. The client (seller) sells goods to the buyer and prepared invoice with a notation that debt due on account of this invoice is assigned to and must be paid to the Factor(Financial Intermediary)

2. The client(seller) submits invoice copy only with delivery challan showing receipt of goods by buyer, to the Factor

3. The Factor, after scrutiny of these papers, allows payment (usually upt0 80% of invoice value). The balance is retained as Retention Money (Margin Money). This is also called Factor Reserve.

4. Once the invoice is honored by the buyer on due date, the retention money credited to the client’s account

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5. Till the payment of bills, the Factor follows up the payment and sends regular statements to the client

Statues applicable To Factoring Indian Contract Act Sale of Goods Act Transfer of Property Act Banking Regulation Act Foreign Exchange Regulation Act

Factoring Companies in India

• Canbank Factors Limited

• SBI Factors and Commercial Services Pvt. Ltd

• . The Hongkong and Shanghai Banking Corporation Ltd.

• Foremost Factors Limited

• Global Trade Finance Limited

• Export Credit Guarantee Corporation of India Ltd.

• Small Industries Development Bank of India (SIDBI) Services rendered by factor

Factor evaluates creditworthiness of the customer (buyer of goods) Factor fixes limits for the client (seller) which is an aggregation of the limits fixed for each of the customer (buyer) Client sells goods/services Client assigns the debt in favor of the factor Client notifies on the invoice a direction to the customer to pay the invoice value of the factor. Client Forwards invoice/copy for factor along the receipted delivery challans Factor provides credit to client to the extent of 80% of the invoice value and also notifies to the customer Factor periodically follows with the customer When the customers pays the amount of the invoice the balance of 20% of the invoice value is passed to the client recovering necessary interest and other charges. If the customer does not pay, the factor takes recourse to the client.

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Advantages of Factoring

Factoring is becoming popular all over the world on account of various services

offered by the institutions engaged in it. Factors render services ranging from bill

discounting facilities offered by the commercial banks to total take over of

administration of credit sales including maintenance of sales ledger, collection of

accounts receivables, credit control, protection from bad debts, provision of finance

and rendering of advisory services to their clients. Thus factoring is a tool of

receivables management employed to release the funds tied up in credit extended to

customers and to solve problems relating to collection, delays and defaults of the

receivables.

A firm that enters into factoring agreement is benefited in a number of ways, some of

the important benefits are

(1) The factors provides specialised services with regard to sales ledger administration

and credit control and relieves the client from the botheration of debt collection. He

can concentrate on the other major areas of his business and improve his efficiency.

(2) The advance payments made by the factor to the client in respect of the bills

purchased increase his liquid resources. He is able to meet his liabilities as and when

they arise thus improving his credit standing position before suppliers, lenders and

bankers. The factor's assumption of credit risk relieves him from the tension of bad

debt losses. The client can take steps to reduce his reserve for bad debts.

(3) It provides flexibility to the company to decide about extending better terms to

their customers.

(4) The company itself is in a better position to meet its commitments more promptly

due to improved cash flows.

(5) Enables the company to meet seasonal demands for cash whenever required.

(6) Better purchase planning is possible. Availability of cash helps the company to

avail cash discounts on its purchases.

(7) As it is an off balance sheet finance, thus it does not affect the financial structure.

This would help in boosting the efficiency ratios such as return on asset etc.

(8) Saves the management time and effort in collecting the receivables and in sales

ledger management.

(9) It reduces the credit risk of the seller. Credit risk is the risk of non-payment of a

loan by the borrower. In other words, we can define it as the risk that the borrower

may not repay the principal amount or the interest payments associated with it (or

both) partly or fully. This results in the loss for the lender in the form of disruption of

cash flows and increased collection cost.

Where credit information is also provided by the factor, it helps the company to avoid

bad debts.

(10) It ensures better management of receivables as factor firm is specialised agency

for the same.

The factor carries out assessment of the client with regard to his financial, operational

and managerial capabilities whether his debts are collectable and viability of his

operations. He also assesses the debtor regarding the nature of business, vulnerability

of his operations; and assesses the debtor regarding the nature of business,

vulnerability to seasonality, history of operations, the term of sales, the track record

and bank report available on the past history.

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Limitations

The above listed advantages do not mean that the factoring operations are totally free

from any limitation. The attendant risk itself is of very high degree. Some of the main

limitations of such transactions are listed below:

(1) It may lead to over-confidence in the behavior of the client resulting in overtrading

or mismanagement.

(2) The risk element in factoring gets accentuated due to possible fraudulent acts by

the client in furnishing the main instrument "invoice" to the factor. Invoicing against

non-existent goods, pre-invoicing (i.e. invoicing before physical dispatch of goods),

duplicate-invoicing (i.e. making more than one invoice in respect of single transaction)

are some commonly found frauds in such operations, which had put many factors into

difficulty in late 50's all over the world.

(3) Lack of professionalism and competence, underdeveloped expertise, resistance to

change etc. are some of the problems which have made factoring services unpopular.

(4) Rights of the factor resulting from purchase of trade debts are uncertain, not as

strong as that in bills of exchange and are subject to settlement of discounts, returns

and allowances.

(5) Small companies with lesser turnover, companies having high concentration on a

few debtors, companies with speculative business, companies selling a large number

of products of various types to general public or companies having large number of

debtors for small amounts etc. may not be suitable for entering into factoring contracts.

The different types of Factoring are as follows:

Factoring can be both domestic and for exports. In domestic Factoring, the client sells

goods and services to the customer and delivers the invoices, order, etc., to the Factor

and informs the customer of the same.

In return, the Factor makes a cash advance and forwards a statement to the client. The

Factor then sends a copy of all the statements of accounts, remittances, receipts, etc.,

to the customer. On receiving them the customer sends the payment to the Factor.

Different types of Domestic Factoring are as follows:

1. Full Factoring This is also known as “Without Recourse Factoring “. It is the most comprehensive

type of facility offering all types of services namely finance sales ledger

administration, collection, debt protection and customer information. Factor purchases

receivables on the condition that the factor has no recourse to the client, if debts turns

out to be non-recoverable, credit risk is with the factor, higher commission is charges,

factor participates in credit sanction process and approves credit limit given by the

client to the customer. In USA/UK, Factoring is commonly done without recourse.

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2. Recourse Factoring The Factoring provides all types of facilities except debt protection. This type of

service is offered in India. As discussed earlier, under Recourse Factoring, the client’s

liability to Factor is not discharged until the customer pays in full. In recourse

factoring, up to 75 % TO 85% of the invoice receivable is factored, interest is charged

from the date of advance to the date of collection, factor purchases receivables on the

condition that loss arising on account of non-recovery will be borne by the client,

credit risk is with the client, factor does not participate in the credit sanction process,

and usually in India, factoring is done with recourse.

3. Maturity Factoring It is also known as “Collection Factoring “. Under this arrangement, except providing

finance, all other basic characteristics of Factoring are present. The payment is ef-

fected to the client at the end of collection period or the day of collecting accounts

whichever is earlier.

4. Advance Factoring This could be with or without recourse. Under this arrangement, the Factor provides

advance at an agreed rate of interest to the client on uncollected and non-due receiv-

ables. This is only a pre-payment and not an advance. Factor does not make any

advance payment to the client, pays an guaranteed payment date or on collection of

receivables, guaranteed payment date is usually fixed taking into account previous

collection experience of the client, Nominal commission is charges and there is no risk

to Factor.

5. Invoice Discounting In this arrangement, the only facility provided by the Factor is finance. In this method

the client is a reputed company who would like to deal with its customers directly,

including collection, and keep this Factoring arrangement confidential.

The client collects payments from customer and hands it over to Factor. The risk

involved in invoice discounting is much higher than in any other methods.

The Factor has liberty to convert the facility by notifying all the clients to protect his

interest. This service is becoming quite popular in Europe and nearly one third of

Factoring business comprises this facility.

6. Bulk Factoring

It is a modified version of Involve discounting wherein notification of assignment of

debts is given to the customers. However, the client is subject to full recourse and he

carries out his own administration and collection.

7. Agency Factoring

Under this arrangement, the facilities of finance and protection against bad debts are

provided by the Factor whereas the sales ledger administration and collection of debts

are carried out by the client.

International Factoring Traditionally international trade is based on Letters of Credit. When the exporter

knows the importer well with repetitive transactions, he may be willing to export on

‘Open Account ‘basis. On open account the exporter ships the goods without letter of

credit or advance payment.

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Hence, it is credit risky for exporter. If credit is extended (say 90 days since), the

exporter will be quite reluctant as he encounters a credit risk and hence invariably

insists on L/C.

In advanced countries bankers do not make much of a distinction between fund-based

and non-fund based facilities and hence if they have to open L/C’s it may be at the cost

of a reduced overdraft or bills limit for the importer.

The system of L/C’s operates on the “Doctrine of Strict Compliance” which means the

Letter of Credit opening bank will pay money to the exporter only when all the condi-

tions listed in the Letter of Credit document are satisfied by the exporter/shipper of

goods.

In many cases, the documents fail to pass the grade which means the exporter has

simply lost the security available to him under the L/C. Further, now-a-days, goods

move very fast and hence if documents are held up in banks for processing, it causes

delay and inconvenience to the importer.

In the light of the above, international trade has slowly started moving from cash to

credit, and from L/C’s to open account sales. International Factoring is a service which

helps the exporter and importer to trade on open account terms.

Types of International Factoring The client can choose any type of international factoring depending upon exporter –

client needs and his price bearing capacity.

Two Factor Systems This is the most common system of international factoring and involves four parties

i.e., Exporter, Importer, Export Factor in exporter’s country and Import Factor in

Importer’s country.

The functions of the export Factor are:

i. Assessment of the financial strength of the exporter

ii. Prepayment to the exporter

iii. Follow-up with the Import Factor

iv. Sharing of commission with the import Factor

The functions of the Import Factor are:

i. Maintaining the books of the exporter in respect of sales to the debtors in his country

ii. Collection of debts from the importer and remitting the proceeds to the exporter’s

Factor

iii. Providing credit protection in case of financial inability on the part of any of the

debtors

The following are the important types of International Factoring

1. Single / Direct Factoring System

In this system, a special agreement is signed between two Factoring companies for

single Factoring. Whereas in Two Factor System, credit is provided by import Factor

and pre-payment, book keeping and collection responsibilities remain with export

Factor.

For this system to be effective there should be strong co-ordination and co-operation

between two Factoring companies. Pricing is lower when compared to Two Factor

System.

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2. Direct Export Factoring

Here only one Factoring company is involved, i.e., export Factor, which provides all

services including finance to the exporter.

3. Direct Import Factoring

Under this system, the seller chooses to work directly with Factor of the importing

country. The Factoring agreement is executed between the exporter and the import

Factor. The import Factor is responsible for sales ledger administration, collection of

debts and providing bad debt protection up to the agreed level of risk cover.

4. Back to Back Factoring

It is a very specialized form of International Factoring, used when suppliers are selling

large volumes to a few debtors for which it is difficult to cover the credit risk in

International Factoring.

Functions of a Factor • Administration of Sales Ledger – the factor maintains the client’s sales ledger. On

transacting a sales deal, an invoice is sent by the client to the customer and a copy of the same is sent to the factor. The ledger is generally maintained under the open item method in which each receipt is matched against the specific invoice. The factor also gives periodic reports to the client on the current status of his receivables, receipts of payments from the customers and other useful information. In addition, the factor also maintains a customer wise record of payments spread over a period of time so that any change in the payment pattern can be easily identified.

• Provision of collection facility - The factor undertakes to collect the receivables on behalf of the client relieving him of the problems involved in collection and enables him to concentrate on other important functional areas of the business. The also enables the client to reduce the cost of collection by way of savings in manpower, time and efforts.

• Financing trade debts - The unique feature of factoring is that a factor purchases the

book debts of his client at a price and the debts are assigned in favour of the factor

who is usually willing to grant advances to the extent of 80-85 percent of the assigned

debts. The balance 15-20 is retained as a factor reserve. Where the debts are factored

with recourse, the finance provided would become refundable by the client in case of

non-payment by the buyer. However, where the debts are factored without recourse,

the factor’s obligation to the seller becomes absolute on the due date of the invoice

whether or not the buyer makes the payment. • Credit control and credit protection - Assumption of credit risk is one of the

important functions of a factor. This service is provided where debts are factored without recourse. The factor in consultation with the client fixes client limits for approved customers. Within limits, the factor undertakes to purchase all trade debts of the customer without recourse. i.e the factor assumes the risk of default in payment by customers. Arising from this function of the factor, there are two important incidental benefits accruing to the client, first, factoring relieves the client of the collection work, secondly, with access to extensive information available on the financial standing and credit rating of individual customers and their track record of payments, the factor is able to advise the client on the credit worthiness of potential customers leading to better credit control.

The factor provides various services at some charge in the form of a commission

expressed as a value of debt purchased. It is collected in advance. The commission is

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in the form of interest charged for the period between the date of advance payment and

date of collection/guarantee payment date for short term financing as advance part

payment. It is also known as discount charge.

The cost of factoring services primarily comprises of the following two components:

1. Administrative charges /factoring fees - This is charged towards providing various

services to the clients namely

(a) sales ledger administration

(b) credit control including processing, operational overheads and collection of debts

(c) providing, protection against bad debts.

This charge is usually some percent of the projected sales turnover of the client for the

next twelve months. It varies between 1 to 2.5 percent of the projected turnover.

The quantum of charges depends upon the following factors.

a) Type of industry

b) Financial strength of the client as well as of the debtors

c) Volume of sales

d) Average invoice value

e) Terms of trade

f) Type(s) of service(s) offered

g) Required profit margin to the factor

h) Extent of competition

i) Security to the factor etc.

2. Discount charges: This is levied towards providing instant credit to the client by

way of prepayment. This is normally linked with the base rate of the parent company

or the bank from which the factoring institution is borrowing money, say, 1 to 2.5

percent above the said rate.

Potential in the Indian context

Factoring is being viewed as a source of short-term finance. The estimated aggregate

potential demand for factoring (finance) would be about Rs 4,000 crores (SBI Monthly

Review, 1989). There seems to be a tendency to view factoring primarily as a

financing function - a source of funds to fill the void of bank financing of receivables

for small-scale industries and others. This attitude is fraught with dangers and could

lead to a "catch 22" situation. In launching factoring service, the thrust should be in the

twin areas of receivables management, and credit appraisal; factoring agencies should

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be viewed as vehicles of development of these skills. Since the small-scale sector lacks

these sophisticated skills, factors should be able to fill the gap. Giving priority to

financing function would be self-defeating as receivable management would be given

the back-seat. It is for the factors to generate the necessary surpluses to mop up the

additional resources and then embark on financing function. However, for policy

reasons, should these go hand in hand, then the accent should be on receivable

management otherwise, these agencies would end up as financing bodies. From the

firm's point of view, factoring arrangements offer certain financial benefits in the form

of savings in collection costs, reduction in bad debt losses, and reduction in interest

cost of investment in receivables. On the other hand, the firm incurs certain costs, in

the form of commissions and interest on advances. Therefore, to assess the financial

desirability of factoring as an alternative to in-house management of receivables, the

firm must assess the net benefit of this option, using the profit criterion approach. The

factors have to establish their credibility in offering better management of receivables

and financing at competitive rates to the clients.

Conclusion

Factoring is an accepted method of receivables financing across the globe and is

regulated by a stringent set of rules and procedures. Initially, factoring was not a typical

or mainstream financial service in the absence of a legislation. However, with the

enactment of Factoring Regulation Act in 2011, the necessary legal framework is now

in place for factoring volumes to grow. But unfortunately, reservations on part of

corporates and PSU buyers to accept assignment of receivables made in favour of

factors, issues with the legal system and dominance of banking have been restricting

the growth. Given the fact that the RBI and several other associations have been taking

initiatives to create an awareness about factoring and its superiority as a receivable

management service, an increase in the volumes is expected.

Short questions

1. What are the advantages and disadvantages of factoring?

2. What is more important factoring or forfeiting and why?

3. Discuss the mechanisms of factoring and forfeiting.

4. What is international factoring? Who are the parties‟ involved in it?

5. Explain the recommendation of Kalyansundaram committee.

6. Distinguish between factoring and forfaiting.

Factoring is always used as a tool for short term financing whereas forfaiting is for

medium term financing at a fixed rate of interest. Factoring is generally employed to

finance both the domestic and export business. But forfaiting is invariably employed in

export business only. The central there of factoring is the purchase of the invoice of

the client where it is only the purchase of the export bill under forfaiting. Forfaiting

is done without recourse to the client where as it may or may not be so under

factoring. The bills under forfaiting may be held by the forfaiting till the due date or

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they can be sold in the secondary market or to any investor for cash. Such a possibility

does not exist under factoring.

7. Discuss the benefit of forfaiting

8. Explain Factoring in India

There are two factoring companies in public sector banks. 1. SBI factors and

commercial service ltd. 2. Can bank factor ltd. 1.SBI Factor and commercial service

ltd, was floated jointly by SBI, SIDBI and union bank of India in March 1991. This

factory company has become an associate member of the factors chain international,

based in Amsterdam. It also joined recently EDIFACT- which is a communication

network of chain international of electronic data interchange. 2. Can bank factor ltd.

Can bank factor ltd was jointly promoted by Canara bank, Andhra bank and SIDBI, in

august 1992 to operate in south India. It paid up capital of Rs 10 cores is contributed in

the ratio of 60:20:20 by its three promoters. It can have its operations throughout India

due to the lifting up of restriction by RBI.

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