Meaning of Factoring
Meaning of Factoring
Factoring is derived from a Latin term “facere” which means ‘to make or do’. Factoring is
an arrangement wherein the trade debts of a company are sold to a financial institution at a
discount. The factor is an agent who buys the accounts receivables (Debtors and Bills
Receivables) of a firm and provides finance to a firm to meet its working capital
requirements.The main advantage of factoring is that the small or big business firm
receives short term finance (working capital) to meet day-to- day payments.
It is the oldest form of financial service relating to management and financing of debts
offered by financial institutions. Here a company sells its accounts receivables at a
discount to a factor, which then assumes the credit risk of the debtors and receives cash as
the debtors settle their accounts.
Features of Factoring:
The features of factoring have been explained below:
1. It is very costly.
2. In factoring there are three parties: The seller, the debtor and the factor.
4. Here the full liability of debtor has been assumed by the factor.
5. Factor has the right to take any legal action required to recover the debts.
The Factoring Regulation Act 2011 governs the registration of factors and regulating the
assignment of receivables and the associated obligations.
Factoring Process
The firm enters into a factoring arrangement with a factor, which is generally a
financial institution, for invoice purchasing
Whenever goods are sold on credit basis, an invoice is raised and a copy of the same
is sent to the factor.
The debt amount due to the firm is transferred to the factor through assignment
and the same is intimated to the customer.
On the due date, the amount is collected by the factor from the customer.
After retaining the service fees, the remaining amount is sent to the firm by the
factor
a. Maintenance of book-debts
b. Credit coverage
The factor accepts the risk burden of loss of bad debts leaving the seller to concentrate on
his core business.
c. Cash advances
Around eighty percent of the total amount of accounts receivables is paid as advance cash
to the client.
d. Collection service
Issuing reminders, receiving part payments, collection of cheques form part of the
factoring service.
e. Advice to clients
From the past history of debtors, the factor is able to provide advices regarding the credit
worthiness of customers, perception of customers about the products of the client, etc.
Types of factoring
a Recourse and Non-recourse Factoring: In this type of arrangement, the financial
institution, can resort to the firm, when the debts are not recoverable. So, the credit
risk associated with the trade debts are not assumed by the factor.
On the other hand, in non-recourse factoring, the factor cannot recourse to the
firm, in case the debt turn out to be irrecoverable.
If the agreement between the borrower and lender calls for “no recourse” it means
the lender has no option to turn to the business owner for any shortfall between what
the company owed the lender, and what the liquidated assets provided.
Disclosed and Undisclosed Factoring: The factoring in which the factor’s name is
indicated in the invoice by the supplier of the goods or services asking the purchaser
to pay the factor, is called disclosed factoring.
Conversely, the form of factoring in which the name of the factor is not mentioned
in the invoice issued by the manufacturer. In such a case, the factor maintains sales
ledger of the client and the debt is realized in the name of the firm. However, the
control is in the hands of the factor.
Domestic and Export Factoring: When the three parties to factoring, i.e. customer,
client, and factor, reside in the same country, then this is called as domestic
factoring.
Procedure
The seller sells the goods to the buyer and raises the invoice on the customer.
The seller then submits the invoice to the factor for funding. The factor verifies the
invoice.
The factor then waits for the customer to make the payment to him.
On receiving the payment from the customer, the factor pays the remaining amount
to the client.
Fees charged by factor or interest charged by a factor may be upfront i.e. in advance
or it may be in arrears. It depends upon the type of factoring agreement.
In case of non — recourse factoring services factor bears the risk of bad debt so in
that case factoring commission rate would be comparatively higher.
The rate of factoring commission, factor reserve, the rate of interest, all of them is
negotiable. These are decided depending upon the financial situation of the client.
The factor gets control over the client’s debtors, to whom the goods are sold on credit or
credit is extended and also monitors the client’s sales ledger.
In forfating credit is advanced to the importer of capital goods for a certain period.
The amount of payment is receivable in any convertible currency. The letter of credit or
bank guarantee is given by the importer's bank. Finance is provided on a fixed or floating
interest rate. The forfaiter can be an individual or an entity, like a bank or a financial
institution. The risks associated with the forfaiting are credit risk, transfer risk, foreign
exchange rate risk or interest rate changes.
Moreover, it involves buying of international trade receivables such as the bill of exchange
or promissory notes at a discount, on a 100% without recourse basis. This means that the
seller (client) is eligible for complete credit protection and the exporter has no liability if
the importer defaults in the payment.
PROCESS OF FORFAITING
1. Goods are sold by the exporter (seller) to the importer (buyer), based on deferred
payment distributed over three to five years.
2. A series of promissory notes are drawn by the importer in favour of the exporter, for
the amount to be paid in future, which includes the amount of interest.
3. Further, the promissory notes issued are guaranteed by a recognized international
bank, often importer’s banker. The guaranteeing bank assures that it covers the
failure in payment of the buyer if any.
4. The notes so availed, are sold by the exporter to the forfaiter (exporter’s banker), at a
discount on a non-recourse basis to the seller.
5. Now, when the forfaiter buys those notes, it can hold these notes until it gets
matured or he can sell them to the investor’s group, who may be interested in buying
an unsecured note having high-yielding potential or freely trade the debt instrument
in the secondary market.
6. The unconditional trade bills and notes hold legal enforceability, which ensures
security to the forfaiter or next buyer of the instrument. The maturity of these
instruments may lie between one month to ten years.
Conclusion
Factoring helps smooth running of business by getting short term credits from financial
institutions against accounts receivables. Forfaiting is a variation of factoring with focus on
international exports.
Advantages of Factoring:
Factoring has several advantages, some of which are:
The company receives advance payment from the factor which improves its immediate
cash inflows. Factoring does not require to chase the debtors for collecting outstanding
amount and consequently the management may concentrate on other important issues.
Disadvantages of Factoring:
Factoring is also associated with some disadvantages such as:
i. It is very costly, as a huge discount is to be paid to the factor.
ii. Factors may adopt some harsh techniques for the recovery of debt which is not always
acceptable to the debtors and ultimately the relationship between company and debtors
deteriorates.
iii. Factors only purchase the invoices of a reputed company; a new company does not get
the benefit of factoring.