FACTORING MODULE – 2.9

DR R RESHMI,

ASSISTANT PROFESSOR,

RESEARCH DEPARTMENT

OF COMMERCE

FAROOK COLLEGE,

CALICUT

Introduction 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 specialised 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.

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

in as little as 24 hours.

• Factoring shortens the collections process

. Debt can be a useful tool to build and sustain a business.

• Getting a business loan has always been challenging.

• For small businesses that don’t have a collection department or adequate

personnel, a factoring company can provide a much-needed service.

The term 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 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

Evolution of Factoring

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.

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.

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 thee 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”.

(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.

Common Terminology Used In A Factoring Transaction

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

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

• Can bank Factors Limited

• SBI Factors and Commercial Services Pvt. Ltd

• The Hong Kong 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.

Advantages of Factoring

(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.

(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.

(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

(6) Better purchase planning is possible.

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

structure.

(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.

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

agency for the same.

(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.

The above listed advantages do not mean that the factoring

operations are totally free from any limitation.

(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.

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.

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

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 ef­fected to

the client at the end of

collection period or the day

of collecting accounts

which­ever is earlier.

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 receiv­ables. 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.

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.

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

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.

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 condi­tions 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.

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

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.

Direct Export Factoring

Here only one Factoring

company is involved,

i.e., export Factor,

which provides all

services including

finance to the exporter.

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.

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.

. 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 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

In launching factoring service, the thrust should be in the twin areas of

receivables management, and credit appraisal; factoring agencies should

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.

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