term paper on factoring

M.F.I. C.S.J.M.U.KANPUR FACTORING

S.No TOPIC Page No.

1 Introduction 2-3

2 Function Of Factoring 3-4

3 Types Of Factoring 5-7

4 Mechanism Of Factoring 7-8

5 A Study Group Of Factoring 9

6 Factoring Organization In India 10

7 Advantages Of Factoring 10-12

8 Problems In Factoring 12-13

9 Conclusion 14

10 Bibliography 15

Dr. S. PANDIYA


INTRODUCTION OF 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.

We will see different types of factoring in this article. The account receivable in factoring can

either be for a product or service. Examples are factoring against goods purchased, factoring for

construction services (usually for government contracts where the government body is capable of

paying back the debt in the stipulated period of factoring. Contractors submit invoices to get

cash instantly), factoring against medical insurance etc. Let us see how factoring is done against

an invoice of goods purchased.

1. Usually the period for factoring is 90 to 150 days. Some factoring companies allow even

more than 150 days.

2. Factoring is considered to be a costly source of finance compared to other sources of

short term borrowings.

3. 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.

4. Bad debts will not be considered for factoring.

Dr. S. PANDIYA


5. Credit rating is not mandatory. But the factoring companies usually carry out credit risk

analysis before entering into the agreement.

6. Factoring is a method of off balance sheet financing.

7. 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.

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

9. 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).

FUNCTION OF FACTROING

MAINTENANCE OF SALES LEDGER: -

A factor maintains sales Ledger for his client firm. An invoice is sent by the client to the

customer, a copy of which is marked to the factor. The client need not maintain individual sales

ledgers for his customers. On the basis of the sales ledger, the factor reports to te client about the

current status of his receivables, as also receipt of payments from the customers and as part of a

package, may generate other useful information. With the help of these reports, the client firm

can review its credit and collection policies more effectively.

COLLECTION OF ACCOUNTS RECEIVABLES-

Under factoring arrangements factoring institution undertakes the responsibility of collecting the

receivables for its client. Thus, the client firm is relieved of the regours of collecting debts and

thereby is enable to concentrate on improving the purchase, production, marketing and other

Dr. S. PANDIYA


managerial aspects of the business. With the help of trained manpower backed by infrastructural

facilities factoring agency systematically undertakes follow up measure and makes timely

demand in the debtors to pay the amounts.

Credit control and credit protection –

Another useful service rendered by a factoring institution is credit control and protection. As a

factor maintains extensive information records (generally computerized) about the financial

standing and credit rating of individual customers and their track record of payments, he is able

to advise its client on whether to extend credit to a buyer or not and if it is to be extended the

amount of the credit and the period therefore. Further, the factor establishes credit limits for

individual customers indicating the extent to which he is prepared to accept the client’s

receivable on such customers without recourse to the client. This specialized service of a factor

assists clients to handle a far greater volume of business with confidence than would have been

possible otherwise.

In addition, factor provides credit protection to his client by purchasing without recourse to him,

every debt of approved customers (within the stipulated credit limit) and assumes the risk of

default in payment by customers only in case of customer’s financial inability to pay.

Advisory functions –

At times, factoring institutions render certain advisory services to their clients. Thus, as a credit

specialist a factor undertakes comprehensive studies of economic conditions and trends and thus

is in a position to advise its clients of impending developments in their respective industries.

Many factors employ individuals with extensive manufacturing experience who can even advise

on work load analysis, machinery replacement programs and other technical aspects of a client’s

business.

Dr. S. PANDIYA


Factors also help their client in choosing suitable sales agents/ seasoned personnel because of

their close relationships with various individuals and non-factored organizations.

TYPES OF FACTORING

FULL FACTORING:-

Under full factoring arrangement, a factor renders services f collection of receivables and

maintains sales ledgers, credit protection. On the basis of creditworthiness of the firm a monetary

limit is fixed up to which trade credit provided by the client will be taken over by the factor

without recourse to the client? The liability of the factor is limited only to the defaults arising out

of customer’s financial inability to pay. If the payment is withheld for reasons of dispute

regarding inherent defect in goods, quality, quantity, counter claim, etc. recourse will be

available to the factor against the client.

RECOURSE FACTORING:-

In this type of factoring the factor does not provide any protection to the client against a

customer’s failure to pay debts. It may, therefore, not be necessary for the factor to either

approve the customer or fix a credit limit. If the customer does not pay the invoice on maturity

for any reason, the factor is entitled to recover from the client the amount paid in advance.

MATURITY FACTORING:-

This type of factoring involves no financing ab nitio and hence no drawing limit is made

available to the client. But the factor administers the client’s sales ledger and renders debt

collection services. The amount of each invoice is made over to the client at te end of the credit

period on an agreed maturity date, less the factor’s charges. The maturity date is decided upon at

Dr. S. PANDIYA


the commencement of the agreement by reference to the average-time taken by the client to

collect a debt. The maturity date bears no relation to the date on which the receivable is actually

due for payment as it is a ‘estimated date of collection.

Such factoring could be with or without recourse. If it is without recourse, the amount will be

made over to the client regardless of whether the factor has been able to collect the invoice or

not. If the debtor becomes insolvent, or proof of insolvency, payment will be made to the client

even before maturity. In with recourse factoring, the factor will either pay the client on collection

of invoice or on maturity date with recourse later on.

ADVANCE FACTORING:-

This kind of factoring institution is prepared to pay for debts in advance of receiving the

payment due from the customers. This is only a prepayment and not an advance. A drawing limit

is made available to the client as soon as the invoice is accounted for.

INVOICE DISCOUNTING INSTITUTION:-

Under this arrangement the factor buys all or selected invoices of its client at a discount. The

factoring institution does not maintain sales ledger for its client nor undertakes debt collection

function. It only provides finance to its client.

DISCLOSED FACTORING:-

In disclosed factoring client's customers are notified of the factoring agreement. Disclosed type

can either be recourse or non recourse.

UNDISCLOSED FACTORING:-

In undisclosed factoring, client's customers are not notified of the factoring arrangement. Sales

ledger administration and collection of debts are undertaken by the client himself. Client has to

Dr. S. PANDIYA


pay the amount to the factor irrespective of whether customer has paid or not. But in disclosed

type factor may or may not be responsible for the collection of debts depending on whether it is

recourse or non recourse.

BUYER-BASED FACTORING INSTITUTION:-

Buyer-based factoring institution is concerned with factoring all the buyer’s payables. Thus, the

factor would maintain a list of ‘approved buyers’ and any claims on such buyer (by any seller)

would be factored without recourse to the seller.

SELLER-BASED FACTORING:-

This type of factoring institution takes over the credit function of the seller entirely. After

invoicing its customer the seller Submits a copy of the invoice, the delivery Challan, the buy sell

contract and related papers like quality stipulations and test certificate to the factor who takes

over the remaining operations like reminding the buyer for payment, maintaining its account and

collecting the amount. The seller closes his transaction after assigning the debt to the factor, by

treating the transaction as a cash sale. In such a case, the factor is also able to supply additional

information to the management, viz; approved, unapproved and disputed claims outstanding,

sales analysis by area, by salesman, by products, etc; excise and sales tax payments and the like.

MECHANICS OF FACTORING:-

An agreement between the firm selling goods or services and the factor is made to specify the

legal obligations and procedural arrangements. When the firm receives an order from a buyer, a

credit approval slip is written and immediately sent to the factoring concern for a credit check.

The factor can give his decision quickly because he maintains elaborate credit files on selected

companies. If the sale is approved by the factor, the goods are dispatched and invoice is clearly

Dr. S. PANDIYA


marked with an inscription notifying the buyer of the goods that the account has been sold and

the payment be made direct to the factor. Notification is a distinctive feature of factoring and not

found in any other form of financing receivable. It is the keystone upon which the services of

factor are based.

1. Despatching invoice to the buyer after credit checking by the factor.

2. Making payment to the factor on the maturity date of the invoiced debt by the buyer.

3. Factor remitting money received to the seller after deducting factor fee in the case of service

factoring or remitting the balance after deducting interest and service fee in the case of service

and finance factoring.

Dr. S. PANDIYA

Factor

ClientCustomer

Pays the amount (In recourse type customer pays through client)

credit sale of goods

Invoice

Submit invoice copy

Payment up to 80% initially

Pays the balance amount


As may be seen from the above diagram that once a routine is established, Continuous circular

flow of goods and funds Lakes place between the seller, the buyer and the factor. Factoring

arrangement, thus helps in speeding up the movement of accounts receivable into cash.

A STUDY GROUP ON FACTORING

The Reserve Bank of India constituted a study group in January 1988 under the chairmanship of

Sri Kalyana Sundaram to examine the feasibility and mechanics of starting factoring

organisations in the country and to make recommendations regarding their Constitution,

organisational set up, scope of activities and related matters as also to look into the feasibility of

export factoring. The study group submitted its report in January 1989 and the important

recommendations are setout below:

There is sufficient scope for introduction of factoring service in India which would be

complimentary to the services provided by banks. The demand for factoring services would

come from engineering, textiles, consumer durables, automobile ancillaries, chemicals, etc.

Factoring organisations may be promoted individually by the leading public sector banks or

jointly by a few among them. To start with there should be only four or five organisations

formed on Zonal basis. Factoring business could also be taken up by the proposed small

Industries Development Bank of India.

The various ways in which factors could raise funds are:

(a) Promotors’ contribution towards equity;

(b) Raising equity capital from public;

(c) Public deposits;

(d) Issue of debentures to public;

(e) Line of credit from Banks; and

(f) Borrowings from short-term money market.

The factors should attempt a mix of the above sources so that their cost of funds does not exceed

13.5 per cent. The Reserve Bank of India may consider to allow them to raise funds from the

Dr. S. PANDIYA


Discount Finance House of India.

The pricing for financing services offered by factors may be around 16 per cent per annum and

the aggregate price for all other services may not exceed 2.5-3 per cent of the debts serviced. The

pricing of various services by factors would depend on various aspects such as credit worthiness

of the customer, his track record, quality of portfolio turnover, an average size of invoices, etc.

FACTOTING ORGANISATION IN INDIA:-

India's first factoring company was set up jointly by Can bank financial services Ltd. , Rashtriya

chemicals and Fertilizer Ltd.

Reserve bank of India permitted Canara bank to set-up Corporate subsidiary with Rs. 10 crore

capital in cooperation with Andhra Bank and Small Industries Development Bank to render

factoring services in southern region. State Bank of India and Punjab and Sind bank have been

permitted to form subsidiary to provide factoring services in northern region. With a view to

catering to the needs of eastern region United Commercial Bank, United Bank o India and

Allahabad Bank have been permitted to float subsidiary with Rs. 5 crores.

The entry of factoring agencies in Indian financial markets has created fear among the bankers

that they may loose the entire account. However, this fear is misplaced. Customers of one bank

have freely gone to merchant banking, leasing or volume capital subsidiaries of some other

banks and utilized their services. There are hardly any cases, where the accounts were shifted.

ADVANTAGES OF FACTORING

REDUCTION OF CURRENT LIABILITIES:-

Dr. S. PANDIYA


From the factoring proceeds of Rs 64 lakh, the bank borrowings are liquidated to the extent of Rs

40 lakh. The balance of Rs 24 lakh can be used by the client for paying off other current

liabilities comprising of trade creditors for goods and services. Creditors for expenses, loan

installments payable, statutory liabilities and provisions. The client may meet any of these

obligations with the balance of Rs 24 lakh. The net effect is to reduce current liabilities by Rs 64

lakh.

IMPROVEMENT IN CURRENT RATIO:-

as the factoring transaction is of the balance sheet, it removes from the asset side receivables

factored to the extent of the prepayment made and on the liabilities side, the current liabilities are

also reduced.

HIGHER CREDIT STANDING:-

there are several reasons why factoring should Improve a client’s standing. With cash flow

accelerated by factoring, the client is able to meet his liabilities promptly as and when they arise.

The factor’s acceptance of the client’s receivables itself speaks highly of the quality of the

receivables. In the case of non-recourse factoring, the factor’s assumption of credit risk relics the

client, to a significant extent, from the problem of bad debts. This enables him to minimize his

bad debts reserve.

IMPROVED EFFICIENCY:-

In order to accelerate cash flow, it is essential to ensure the flow of critical information for

decision making and follow-up and eliminate delays and wastage of man-hours. This requires

sophisticated infrastructure for high level specialization in credit control and sales ledger

administration. Small and medium-sized units are likely to face a recourse constraint in this area.

Factoring is designed to place such units on the same level of efficiency in the areas of credit

control and sales ledger administration as that of the more sophisticated large companies.

Dr. S. PANDIYA


MORE TIME FOR PLANNING AND PRODUCTION:-

In any business concern, it is inevitable that a certain proportion of management time has to be

diverted to credit control. Large companies can afford to have special departments for the

purpose. However smaller units cannot afford it. The factor undertakes the responsibility for

credit control, sales ledger administration and debt collection problems. Thus, the client can

concentrate on functional areas of the business line planning, purchase, production, marketing

and finance.

REDUCTION OF COST AND EXPENSES:-

Since the client need not have a special administrative set-up to look after credit control, he can

have the benefit of reduced overheads by way of savings on manpower, time and efforts. With

the steady and reliable cash flow facilitated y factoring, the clients have many opportunities to

cut costs and expenses like taking supplier’s prompt payment and quantity discounts, ordering

for materials at the right time and at the right place, avoidance of disruption in the production

schedule, and so on.

ADDITIONAL SOURCE:-

The supplier gets an additional source of funding the receivables which eliminates the

uncertainty associated with the collection cycle. More importantly, funds from a factor is an

additional source of finance for the client outside the purview of bank credit.

PROBLEMS IN FACTORING SERVICES

The proposed factoring firms in order to extend their services efficiently and effectively need

reliable and upto date information regarding the financial standing, market reputation and

business prospecLs of firms engaged in buying and selling of goods and services. The factor

cannot afford to associate itself with a concern, whose management is basically unsound and

Dr. S. PANDIYA


whose operations over recent years disclose an unprofitable trend. The factoring firms will,

therefore, be required to stipulate financial criteria for clients to the eligible for factoring. Credit

appraisal of debtors is another important aspect, which necessitates an in-depth study of the

financial position of debtors. But in India at present there are no credit rating agencies.

Therefore, the factoring firms will be required to computers their operations so that enough data

on payment behavior of large number of firms can be generated.

The factoring arrangements are considered to be relatively expensive way of obtaining finances

as compared to other sources. This particularly when the factoring arrangement is without

recourse. Since, the factor bears the risk of default it is natural that he charges more for his

services to compensate the risk. But the factoring firms will have to compete with banks in

financing receivables. Hence, they will be required to operate on thin margins to attract potential

customers.

Imposition of stamp duty on the instrument of transfer is an other problem. The study group is of

the view that to make factoring economically viable, it is essential that assignment of book debts

in favour of factor is exempted from stamp duty. State governments may be advised to remit the

stamp duty.

The concept of factoring in India is quite new. Many traders and manufacturers, particularly

belonging to small and medium sectors are not fully aware of the concept of factoring.

Therefore, it is necessary to educate them about the nature of factoring, types of services offered

by the factoring organizations and also the benefits that would accrue to them if they take

services of factor in the collection of receivables.

Dr. S. PANDIYA


CONCLUSION

Thus, factoring as a tool for assisting traders and manufacturers in the matter of financing and

collection of receivables has an important role to play in a country like India, where the bill

market has not been systematically developed. The development and growth of these

organizations on healthy lines will require legislative as well as other forms of support from

Central and State Governments in the matters relating to exemption of stamp duty’s and recovery

procedures in the case of factored debts. It may also be necessary to set up suitable machinery to

analyze and review the operation of proposed Factoring firms so that the obstacles may be

identified.

Dr. S. PANDIYA


BIBILIOGRAPHY

S.NO TOPIC BOOK

Name

AUTHOR PUBLICATION EDITION P.NO.

1 Function Of

Factoring

Management

of Indian

Financial

Institution

Prof. R.M.

Srivastava

Himalaya

publishing house

Delhi

3rd 1996

Reprint 1997

722-

723

2 Study group

factoring,

Problem in

Factoring

M.F.I.&

Marketing

Prof.

G.S.Batra

Deep & Deep

Publication. New

Delhi

----------- 252-

253

255-

56

3 Advantages Financial

Management

Khan &

Jain

Tata Mc-graw Hill

New Delhi

3rd Edition 17.16-

17.17

INTRODUCTION OF FACTORING & MECHANISM

www.languages.ind.in/factoring.htm

Dr. S. PANDIYA

term paper on factoring

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