Factoring: Silent Features, Types, Steps, Advantage and Limitation!
Factoring is defined as “an outright purchase of credit approved accounts receivables, with the factor assuming bad debt losses.”
The modern factoring involves a continuing arrangement under which a financing institution assumes the credit control/protection and collection functions for its client, purchases his receivables as they arise (with or without recourse to him for credit losses, i.e., customer’s financial inability to pay), maintains the sales ledger, attends to other book-keeping duties relates to such accounts receivables and performs other auxiliary functions.
Factoring is an asset based method of financing as well as specialized service being the purchase of book debts of a company by the factor, thus realizing the capital tied up in accounts receivables and providing financial accommodation to the company.
The book debts are assigned to the factor who collects them when due for which he charges an amount as discount or rebate deducted from the bills. Thus, the factor is an intermediary between the supplier and customers who performs financing and debt collection services.
In a situation where industry is finding it difficult to obtain funds, the need for better management of book debts by companies had arisen. In this backdrop, ‘factoring’ services assumed an important role in global business and could help Indian industry overcome debt collection deficiencies in a big way.
The Managing Director of International Factors Ltd., of Singapore Mr. Eugem Tan Eu Jin, noted that “factoring business had a great potential in India and it was in the best interests of the country to develop this financial intermediary. Banks and other financial institutions can as well diversify in this area to increase their profitability.”
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 documents, etc. to the factor and inform the customer of the same.
In return, the factor makes a cash advance and 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.
In case of export factoring two ‘factors’ are involved. The factor in the customer’s country is called “Import Factor” while the one in the client’s country is called the “Export Factor”. All the transactions remain similar in the case of international factoring, the only difference being that the export factor has to send the shipping documents to the import factor and the import factor has to pass on the ultimate collection to the export factor.
The factor takes over the risk burden of the client and thereby the client s credit is covered through advances.
The factor makes cash advances to the client within 24 hours of receiving the documents.
(iii) Sales ledgering:
As many documents are exchanged, all details pertaining to the transaction are automatically computerized and stored.
(iv) Collection Service:
The factor, buys the receivables from the client, they become the factor’s debts and the collection of cheques and other follow-up procedures are done by the factor in its own interest.
(v) Provide Valuable advice:
The factors also provide valuable advice on country-wise and customer-wise risks. This is because the factor is in a position to know the companies of its country better than the exporter clients.
The types of factoring are discussed below:
(i) Recourse Factoring
(ii) Non-Recourse Factoring
(iii) Advance Factoring
(iv) Confidential and Undisclosed Factoring
(v) Maturity Factoring.
(vi) Supplier Guarantee Factoring
(vii) Bank Participation Factoring
The detail about the Types of Factoring is as follows:
(i) In Recourse factoring the credit risk remains with the client though the debt is assigned to the factor, i.e., the factor can have recourse to the client in the event of non-payment by the customer.
(ii) The Non-Recourse Factoring also called as ‘Old-line factoring’. It is an arrangement whereby he factor has no recourse to the client when the bill remains unpaid by the customer. Thus, the risk of bad debt is absorbed by the factor.
(iii) Where the payment is made by the factor immediately is called Advance Factoring Under this type of factoring, the factor provides financial accommodation apart from non-financial services rendered by him.
(IV) In confidential and undisclosed factoring the arrangement between the factor and the client are left un-notified to the customers and the client collects the bills from the customers without intimating them to the factoring arrangements.
(v) In maturity factoring method, the factor may agree to pay an amount to the client for the bills purchased by him either immediately or on maturity. The later refers to a date agreed upon on which the factor pays the client.
(vi) Supplier Guarantee Factoring is also known as ‘drop shipment factoring’. This happens when the client is a mediator between supplier and customer. When the client is a distributor, the factor guarantees the supplier against the invoices raised by the supplier upon the client and the goods may be delivered to the customer. The client thereafter raises bills on the customer and assigns them to the factor. The factor thus enables the client to make a gross profit with no financial involvement at all.
(vii) In bank participation factoring the bank takes a floating charge on the client’s equity i.e., the amount payable by the factor to the client in .respect of his receivables. On this basis, the bank lends to the client and enables him to have double financing.
The steps involved in factoring are discussed below:
Step I. The customer places an order with the seller (the client).
Step II. The factor and the seller enter into a factoring agreement about the various terms of factoring.
Step III. Sale contract is entered into with the buyer and the goods are delivered. The invoice with the notice to pay the factor is sent along with.
Step IV. The copy of invoice covering the above sale is sent to the factors, who maintain the sales ledger.
Step V. The factor prepays 80% of the invoice value.
Step VI. Monthly Statements are sent by the factor to the buyer.
Step VII. If there are any unpaid invoices follow up action is initiated.
Step VIII. The buyer settles the invoices on expiry of credit period allowed.
Step IX. The balance 20% less the cost of factoring is paid by the factor to the client.
1. It is help to improve the current ratio. Improvement in the current ratio is an indication of improved liquidity. Enables better working capital management. This will enable the unit to offer better credit terms to its customers and increase orders.
2. It is increase in the turnover of stocks. The turnover of stock into cash is speeded up and this results in larger turnover on the same investment.
3. It ensures prompt payment and reduction in debt.
4. It helps to reduce the risk. Present risk in bills financing like finance against accommodation bills can be reduced to minimum.
5. It is help to avoid collection department. The client need not undertake any responsibility of collecting the dues from the buyers of the goods.
1. Factoring is a high risk area, and it may result in over dependence on factoring, mismanagement, over trading of even dishonesty on behalf of the clients.
2. It is uneconomical for small companies with less turnover.
3. The factoring is not suitable to the companies manufacturing and selling highly specialized items because the factor may not have sufficient expertise to asses the credit risk.
4. The developing countries such as India are not able to be well verse in factoring. The reason is lack of professionalism, non-acceptance of change and developed expertise.