ADVANCED FINANCIAL MANAGEMENT

Module-5 (7 Hours)
Receivables Management & Factoring: Nature and objectives of Receivables Management
– Credit management through credit policy variables- marginal analysis- Credit evaluation of
individual accounts and its monitoring receivables - Numerical credit scoring- Control of
accounts receivables- Problems on credit granting decision. (Theory and Problems)
Factoring: Meaning, definition, types & its benefits (Theory only)
Dr UMA K
Assistant Professor
5.1. Receivables Management & Factoring: Receivables management and factoring are
essential components of working capital management. Efficient receivables management
ensures smooth cash flow, while factoring helps businesses convert outstanding invoices into
immediate cash.
1. Meaning of Receivables Management
 Receivables refer to the outstanding payments due from customers for goods or
services sold on credit.
 Receivables management is the process of managing credit sales, collections, and
minimizing bad debts.
 Ensures a healthy cash flow and reduces financial risks.
2. Key Components of Receivables Management
A. Credit Policy
 Establishes guidelines for granting credit to customers.
 Includes credit period, credit limits, and payment terms.
 Example: A company allows customers a 30-day credit period for invoice
payments.
B. Credit Evaluation
 Assessing a customer's creditworthiness before approving credit sales.
 Uses credit scores, financial statements, and past payment history.
 Example: A bank checks a borrower's CIBIL score before approving a loan.
C. Credit Terms & Conditions
 Defines payment deadlines, interest rates on late payments, and discounts for
early payments.
 Example: A supplier offers 2% discount if payment is made within 10 days (2/10,
net 30).
D. Collection Policy
 Methods used to ensure timely payments from customers.
 Soft reminders, legal actions, or third-party collections for overdue payments.
  Example: An e-commerce company sends automated email reminders for pending
invoices.
E. Monitoring Accounts Receivable
 Aging schedule categorizes receivables based on due dates.
 Identifies overdue accounts and potential bad debts.
 Example: A report showing invoices 0-30 days, 31-60 days, 61-90 days overdue.
3. Techniques for Receivables Management
A. Establishing a Credit Policy
 Define who qualifies for credit and under what terms.
 Helps avoid excessive bad debts.
B. Offering Early Payment Discounts
 Encourages customers to pay early, improving cash flow.
 Example: A supplier offers 2% discount if payment is made within 15 days
instead of 30 days.
C. Automating Invoice Processing
 Reduces errors and ensures timely invoicing.
 Example: Businesses use accounting software like QuickBooks or Tally for
automated invoicing.
D. Regular Follow-ups on Receivables
 Sends reminders through emails, calls, or SMS.
 Helps reduce overdue payments.
E. Setting up a Collection System
 Escalates long-overdue payments to a legal team or collection agency.
4. Nature of Receivables Management
A. Part of Working Capital Management
 Receivables (accounts receivable) are short-term assets that impact cash flow and
liquidity.
 Efficient management ensures a steady cash inflow.
B. Focuses on Credit Sales & Collections
 Deals with credit sales policies, payment terms, and collection procedures.
 Example: A manufacturing company selling goods on a 30-day credit basis needs to
track payments efficiently.
C. Balances Sales Growth and Risk
  Encourages credit sales to increase revenue but controls overdue payments and
defaults.
 Example: A retail store offers credit purchases but applies strict payment follow-ups.
D. Includes Credit Policy & Collection Strategies
 Involves evaluating customers' creditworthiness, setting credit limits, and
enforcing collection policies.
 Example: A supplier offers a discount for early payments to encourage quick
collections.
E. Affects Business Liquidity & Profitability
 Delayed payments lead to cash shortages, affecting operations and expansion plans.
 Example: A construction firm facing delayed payments from clients may struggle to
pay workers and suppliers.
F. Requires Continuous Monitoring
 Uses tools like aging schedules and debtor analysis to track overdue accounts.
 Example: A bank regularly reviews customers’ repayment histories before approving
loans.
5. Objectives of Receivables Management
A. Optimize Credit Sales Without Increasing Bad Debts
 Maintain a balance between increasing sales through credit and minimizing
defaults.
 Example: A car dealership offers installment plans but only to customers with
good credit history.
B. Improve Cash Flow and Liquidity
 Ensure timely collection of dues to keep cash available for operations.
 Example: A software company provides monthly invoices to clients to maintain a
steady cash flow.
C. Minimize Collection Period
 Reduce the time between credit sales and actual cash collection.
 Example: An electronics retailer follows up with customers every 15 days for
pending payments.
D. Reduce the Risk of Bad Debts
 Implement strict credit approval processes and collection policies to minimize
losses.
 Example: A wholesale distributor performs credit checks before approving large
orders.
E. Maintain Good Customer Relationships
  Offer flexible payment terms without compromising financial stability.
 Example: A hospital allows patients to pay in instalments for medical treatments
while ensuring payments are received on time.
F. Lower Financing Costs
 Efficient receivables management reduces the need for external borrowing.
 Example: A furniture company ensures faster collections, reducing the need for
short-term bank loans.
G. Enhance Business Profitability
 Faster collections improve cash availability, leading to better reinvestment
opportunities.
 Example: A logistics firm reinvests early payments into expanding its vehicle fleet.
Conclusion: Receivables management is essential for business sustainability and
financial health. It ensures timely payments, reduces bad debts, and improves cash
flow, helping businesses grow while maintaining strong customer relationships.
5.3. Credit management through credit policy variables: Credit management involves
establishing policies and procedures to ensure timely payments from customers, minimize
bad debts, and maintain a healthy cash flow. The effectiveness of credit management
depends on key credit policy variables, which balance sales growth and financial stability.
1. Meaning of Credit Management
 Credit management is the process of granting credit, setting credit terms,
monitoring payments, and recovering dues.
 Aims to reduce default risk while maintaining customer relationships.
 Example: A bank evaluates a borrower's credit score and income level before
approving a loan.
2. Key Credit Policy Variables
A. Credit Standards
 Defines the criteria for granting credit to customers.
 Includes creditworthiness checks based on financial stability, past payment history,
and market reputation.
 Example: A car dealership offers financing only to customers with a credit score
above 700.
B. Credit Terms
 Specifies the duration and conditions for repayment.
 Includes:
o Credit period: Number of days allowed for payment (e.g., 30 days, 60 days).
o Cash discounts: Incentives for early payments (e.g., 2/10, net 30).
 o Interest on late payments: Penalty for overdue amounts.
 Example: A supplier offers a 2% discount if payment is made within 10 days
instead of 30 days.
C. Credit Limit
 Sets the maximum credit amount that a customer can owe at any given time.
 Prevents overexposure to high-risk customers.
 Example: A textile wholesaler sets a $50,000 credit limit per retailer based on their
order history.
D. Collection Policy
 Defines the process of recovering overdue payments.
 Includes reminders, follow-ups, legal actions, and third-party collections.
 Example: A utility company sends payment reminders via SMS before
disconnecting services for non-payment.
E. Credit Evaluation Process
 Involves assessing a customer's ability to repay credit before approval.
 Uses financial analysis, credit ratings, and historical payment behavior.
 Example: A corporate lender checks a company’s debt-to-equity ratio and
profitability before issuing a loan.
F. Monitoring Accounts Receivable
 Regularly tracking outstanding invoices using aging schedules.
 Identifies customers with frequent delays and adjusts credit policies accordingly.
 Example: A retail store classifies customers into “good,” “moderate,” and “risky”
categories based on past payments.
G. Bad Debt Management
 Includes provisions for doubtful debts and legal actions against defaulters.
 Helps reduce financial losses from unrecoverable accounts.
 Example: A telecom company writes off long-overdue unpaid bills after multiple
collection attempts.
3. Importance of Credit Policy Variables
✅ Improves cash flow and liquidity.
✅ Reduces bad debt risk.
✅ Enhances customer satisfaction through flexible credit terms.
✅ Helps in better financial planning.
4. Conclusion: Effective credit management through well-defined credit policy variables
helps businesses maintain financial stability while boosting sales. Companies must strike a
balance between offering credit and ensuring timely collections to maximize profits.
5.4. Marginal analysis: Marginal analysis in receivables management is used to determine
the optimal level of credit sales by analysing the costs and benefits of extending credit. It
helps businesses balance increased sales with the risk of bad debts and additional costs.
1. Meaning of Marginal Analysis in Receivables Management
 Marginal analysis is a decision-making tool that examines the additional costs and
benefits of increasing or decreasing credit sales.
 Businesses use it to determine whether granting additional credit will be
profitable.
 Example: A company may increase its credit period from 30 days to 60 days to
boost sales, but it must analyze whether the additional profit outweighs the increased
cost of financing and risk of bad debts.
2. Objectives of Marginal Analysis in Receivables Management
✅ Maximize profitability by determining the optimal level of credit sales.
✅ Minimize bad debts by analyzing credit risk.
✅ Optimize cash flow by balancing increased sales and delayed payments.
✅ Improve decision-making regarding credit policies and collection strategies.
3. Key Components of Marginal Analysis in Receivables Management
A. Marginal Revenue (MR) from Credit Sales
 The additional revenue generated from extending more credit.
 Example: A manufacturing firm offers credit to more customers, leading to a 5%
increase in sales.
B. Marginal Cost (MC) of Receivables
 The additional costs incurred due to increased credit sales, including:
o Financing cost: The interest cost of funds tied up in receivables.
o Bad debt losses: The risk of non-payment.
o Collection costs: Additional efforts required to collect payments.
 Example: A retailer extends credit to new customers and incurs extra collection
expenses of $5,000 per month.
C. Net Marginal Benefit (NMB)
 Formula: Net Marginal Benefit=Marginal Revenue−Marginal Cost\text{Net
Marginal Benefit} = \text{Marginal Revenue} - \text{Marginal Cost}
 If NMB is positive, extending credit is profitable.
 If NMB is negative, the company should reconsider its credit policy.
4. Steps in Marginal Analysis for Receivables Management
Step 1: Estimate Additional Sales from Credit Expansion
 Determine how much sales will increase if credit terms are relaxed.
 Example: A furniture company expects a 20% sales increase if it extends the credit
period from 30 to 60 days.
Step 2: Calculate Additional Costs
 Identify the financing costs, bad debts, and collection expenses.
 Example: If the company’s cost of capital is 12% per year, the additional financing
cost for extended receivables is $10,000 annually.
Step 3: Compare Marginal Revenue and Marginal Cost
 If Marginal Revenue > Marginal Cost, credit expansion is beneficial.
 If Marginal Revenue < Marginal Cost, the company should restrict credit policies.
Step 4: Decide on Credit Policy Adjustment
 If net marginal benefit is positive, the company can extend credit further.
 If negative, the company must tighten credit standards or improve collection
policies.
5. Example of Marginal Analysis in Receivables Management
Scenario:
A company sells electronic gadgets and is considering extending credit to new customers.
Factors Before Credit Expansion After Credit Expansion
Sales Revenue $500,000 $550,000
Financing Cost $20,000 $25,000
Bad Debt Losses $5,000 $8,000
Collection Costs $3,000 $5,000
Net Profit $50,000 $52,000
Analysis:
 Marginal Revenue = $50,000 (increase in sales revenue)
 Marginal Cost = ($25,000 - $20,000) + ($8,000 - $5,000) + ($5,000 - $3,000) =
$10,000
 Net Marginal Benefit = $50,000 - $10,000 = $40,000
Conclusion: Since the Net Marginal Benefit is positive ($40,000), the company should
proceed with credit expansion.
6. Advantages of Marginal Analysis in Receivables Management
✅ Helps in strategic decision-making regarding credit policies.
✅ Prevents excessive credit risk by evaluating costs vs. benefits.
✅ Improves cash flow management by optimizing credit terms.
✅ Helps in setting appropriate credit limits for customers.
7. Limitations of Marginal Analysis in Receivables Management
❌ Estimating marginal costs and revenues accurately can be difficult.
❌ Market conditions may change, affecting sales projections.
❌ Does not consider qualitative factors like customer goodwill and competition.
Conclusion: Marginal analysis is an effective tool in receivables management that helps
businesses optimize credit sales while controlling costs. By balancing increased sales and
credit risk, companies can maximize profitability and maintain financial stability.
5.5. Credit evaluation of individual accounts and its monitoring receivables: Effective
credit evaluation and monitoring of receivables are essential for minimizing the risk of bad
debts and ensuring a smooth cash flow. Businesses must assess the creditworthiness of
customers before extending credit and continuously track receivables to maintain financial
stability.
1. Credit Evaluation of Individual Accounts
A. Meaning of Credit Evaluation
 The process of analyzing a customer's financial capability and creditworthiness
before granting credit.
 Helps in reducing bad debt risk and ensuring timely payments.
 Example: A bank checks a customer’s credit score and income stability before
approving a loan.
B. Steps in Credit Evaluation
1. Collection of Customer Information
 Businesses collect financial and personal details of the applicant.
 Sources of information:
o Past transaction records
o Credit reports from agencies (e.g., CIBIL, Experian)
o References from other suppliers
 Example: A car financing company requires salary slips and bank statements
before approving a loan.
2. Analysis of Financial Strength
 Examines the customer's income, profitability, and liquidity.
 Key financial ratios used:
o Debt-to-equity ratio (lower is better)
 o Current ratio (higher indicates good liquidity)
 Example: A corporate lender assesses a company's balance sheet before granting a
business loan.
3. Credit Scoring and Credit Rating
 Assigning a numerical score based on factors like past repayments, outstanding
debts, and payment history.
 Example: Banks grant loans to individuals with a CIBIL score above 750.
4. Establishing Credit Terms and Limits
 Deciding on the credit period, interest rate, and maximum credit limit.
 Example: A wholesaler may allow retailers a 30-day credit period with a credit limit
of $50,000.
5. Approval or Rejection of Credit Request
 Based on the evaluation, the business either approves, modifies, or rejects the credit
request.
 Example: A construction material supplier denies credit to a new contractor with a
history of late payments.
2. Monitoring of Receivables
A. Importance of Monitoring Receivables
 Ensures timely collection of payments.
 Helps in identifying defaulters early.
 Reduces cash flow problems and bad debts.
 Example: A telecom company sends payment reminders to customers before their
due date.
B. Methods for Monitoring Receivables
1. Aging Schedule Analysis
 Classifies outstanding invoices based on time duration (e.g., 0-30 days, 31-60 days,
61-90 days).
 Helps in identifying overdue payments and risky accounts.
 Example: A manufacturing firm finds that 20% of its invoices are overdue beyond
60 days and takes action.
2. Collection Follow-ups and Reminders
 Sending emails, SMS, and calls for payment reminders.
 Example: An insurance company follows up with policyholders 10 days before the
due date.
3. Credit Limit Review
  Periodically reviewing and adjusting credit limits based on payment behavior.
 Example: A business reduces the credit limit for a customer with frequent late
payments.
4. Use of Credit Insurance
 Protects against losses from unpaid invoices.
 Example: An exporter uses credit insurance to safeguard against non-payment from
international clients.
5. Legal Action and Debt Recovery
 Taking legal steps against defaulters after multiple collection attempts.
 Example: A bank sends legal notices to customers who fail to repay loans after
several warnings.
Conclusion: Effective credit evaluation and monitoring of receivables help businesses
minimize risk, improve cash flow, and reduce bad debts. Companies should adopt a
systematic approach to assess customer creditworthiness and track payments efficiently.
5.6. Numerical credit scoring: Numerical credit scoring is a quantitative method used to
assess an individual's or business’s creditworthiness. It assigns a numerical value based on
various financial and behavioural factors, helping lenders make objective credit decisions.
1. Meaning of Numerical Credit Scoring
 A numerical score that represents a borrower’s ability to repay credit.
 Based on financial data, past repayment history, and credit behavior.
 Higher scores indicate lower risk, while lower scores suggest higher default risk.
 Example: A bank may approve a home loan for an applicant with a credit score of
750+ but reject one with a score below 600.
2. Importance of Numerical Credit Scoring
✅ Provides an objective and consistent measure of credit risk.
✅ Reduces manual errors and subjective bias in credit evaluation.
✅ Helps financial institutions decide loan approval, interest rates, and credit limits.
✅ Enables businesses to predict payment behavior and manage risk effectively.
3. Factors Considered in Numerical Credit Scoring
Weightage (%)
Factor Description
(Example)
Payment History Record of past on-time or late payments 35%
Ratio of used credit to total available
Credit Utilization 30%
credit
Credit History Duration of past credit accounts 15%
 Weightage (%)
Factor Description
(Example)
Length
Mix of credit (loans, credit cards,
Types of Credit 10%
mortgages)
New Credit Inquiries Number of recent loan/credit applications 10%
🔹 Example: A borrower with a history of late payments will get a lower score, while
someone with consistent timely payments will have a higher score.
4. Credit Scoring Formula (Simplified Model)
A basic numerical credit scoring model can be calculated using a weighted formula:
Credit Score=(P×0.35)+(U×0.30)+(H×0.15)+(T×0.10)+(N×0.10)\text{Credit Score} = (P \
times 0.35) + (U \times 0.30) + (H \times 0.15) + (T \times 0.10) + (N \times 0.10)
Where:
 P = Payment History Score (0-100)
 U = Credit Utilization Score (0-100)
 H = Credit History Length Score (0-100)
 T = Types of Credit Score (0-100)
 N = New Credit Inquiries Score (0-100)
5. Example of Numerical Credit Scoring Calculation
Scenario: A borrower applies for a personal loan, and the bank calculates their credit score
using the following individual scores:
Factor Score (out of 100) Weightage (%) Weighted Score
Payment History (P) 90 35% 90 × 0.35 = 31.5
Credit Utilization (U) 70 30% 70 × 0.30 = 21
Credit History Length (H) 80 15% 80 × 0.15 = 12
Types of Credit (T) 75 10% 75 × 0.10 = 7.5
New Credit Inquiries (N) 60 10% 60 × 0.10 = 6
Final Credit Score Calculation:
31.5+21+12+7.5+6=7831.5 + 21 + 12 + 7.5 + 6 = 78
📌 Final Credit Score = 780 (on a scale of 1000)
🔹 Decision: The bank may approve the loan, as the borrower has a relatively high score.
6. Interpretation of Credit Scores (Example - FICO Scale)
 Credit Score Risk Level Loan Approval Chance
800 – 850 Excellent Very High
740 – 799 Good High
670 – 739 Fair Moderate
580 – 669 Poor Low
300 – 579 Very Poor Very Low
🔹 Example: If a borrower has a credit score of 820, they may receive a low-interest rate on
their loan. If their score is 600, they might get a higher interest rate or loan rejection.
7. Advantages of Numerical Credit Scoring
✅ Speeds up loan approvals with automated decision-making.
✅ Reduces bias in evaluating borrowers.
✅ Helps businesses and banks manage credit risk efficiently.
✅ Encourages borrowers to maintain good financial behavior.
8. Limitations of Numerical Credit Scoring
❌ Does not consider qualitative factors (e.g., job stability, future earning potential).
❌ Errors in credit reports can affect scores unfairly.
❌ New borrowers with no credit history may get low scores despite being creditworthy.
9. Conclusion: Numerical credit scoring is a crucial tool in credit risk management. It
enables lenders to evaluate borrowers efficiently, set interest rates, and determine credit
limits based on objective criteria.
5.7. Control of accounts receivables: Accounts receivable control refers to the process of
managing outstanding invoices to ensure timely collections, minimize bad debts, and
optimize cash flow. Effective receivables management helps businesses maintain financial
stability and liquidity.
1. Meaning of Accounts Receivable Control
 It involves monitoring and managing credit sales to ensure customers pay on time.
 Helps businesses reduce bad debts and maintain steady cash flow.
 Example: A company selling goods on a 30-day credit must track due payments and
take action on overdue accounts.
2. Objectives of Controlling Accounts Receivables
✅ Ensure timely collection of outstanding payments.
✅ Minimize bad debts and credit risk.
✅ Optimize working capital management.
✅ Improve profitability by reducing costs of delayed payments.
✅ Maintain good customer relationships while enforcing credit policies.
3. Techniques for Controlling Accounts Receivables
A. Setting Clear Credit Policies
 Establishing guidelines for extending credit to customers.
 Factors include credit period, credit limit, and interest on overdue accounts.
 Example: A company may offer a 45-day credit period but charge 2% interest on
overdue payments.
B. Creditworthiness Assessment
 Evaluating customer financial stability and payment history before granting credit.
 Example: A supplier checks a retailer’s credit score and trade references before
allowing credit purchases.
C. Establishing Credit Limits
 Setting maximum credit that a customer can owe at a time.
 Example: A construction material supplier allows a contractor a credit limit of
$100,000, beyond which cash payment is required.
D. Monitoring and Aging Analysis
 Preparing an Aging Schedule to track outstanding invoices by due dates:
o 0-30 days: Normal
o 31-60 days: Follow-up required
o 61-90 days: Risk of default
o Above 90 days: Collection action required
 Example: A business notices $50,000 is overdue beyond 60 days and intensifies
collection efforts.
E. Timely Invoicing and Payment Reminders
 Sending invoices promptly and following up with payment reminders via email,
SMS, or calls.
 Example: A software company sends automated payment reminders 5 days before
the due date.
F. Offering Early Payment Discounts
 Encouraging prompt payments by offering discounts for early settlements.
 Example: A supplier offers 2% discount for payments made within 10 days
instead of 30 days.
G. Collection Efforts for Overdue Accounts
 Implementing a stepwise collection process:
 1. Friendly reminders for overdue payments.
2. Follow-up calls and emails after 15 days.
3. Legal action or third-party collection agencies if severely overdue.
 Example: A manufacturing company hires a debt collection agency for unpaid
invoices beyond 120 days.
H. Factoring and Invoice Discounting
 Selling receivables to a factoring company to get instant cash.
 Example: A textile firm sells $200,000 in receivables to a factor at a 5% discount for
immediate liquidity.
I. Bad Debt Management and Write-Offs
 Writing off unrecoverable debts to clean the balance sheet.
 Example: A retailer writes off $10,000 from a bankrupt customer as bad debt.
4. Example of Receivables Control in Action
Scenario: A company sells electronics on 30-day credit terms. The finance team notices
that $100,000 is overdue beyond 60 days.
Actions Taken:
✅ Sent payment reminders to customers.
✅ Contacted defaulting customers via phone.
✅ Offered a 5% discount for payments within a week.
✅ Escalated severely overdue accounts to a collection agency.
Result: The company recovered 80% of outstanding receivables and prevented further bad
debts.
Conclusion: Controlling accounts receivables ensures timely cash inflow, reduces financial
risk, and enhances business efficiency. Businesses should implement effective credit
policies, monitoring techniques, and collection strategies to maintain a healthy receivables
balance.
5.8. Problems on credit granting decision. (Theory and Problems) : Credit granting
decisions are crucial for businesses as they determine whether a customer should be given
credit. While offering credit can boost sales and customer loyalty, it also carries risks such
as payment defaults and cash flow issues. Businesses must balance sales growth with risk
management to make effective credit decisions.
1. Meaning of Credit Granting Decision
 It refers to the process of evaluating and deciding whether to extend credit to a
customer.
 A good decision ensures higher sales with minimal risk, while a poor decision
leads to bad debts and financial instability.
  Example: A bank must decide whether to approve a loan request from a new
customer with an average credit history.
2. Key Problems in Credit Granting Decision
A. Lack of Sufficient Customer Information
 Businesses may not have enough financial data on new customers.
 Example: A startup company applies for credit, but its financial history is too short
to assess its reliability.
B. High Risk of Bad Debts
 Some customers may fail to pay or delay payments, leading to losses.
 Example: A furniture retailer extends credit to a struggling business that later
declares bankruptcy.
C. Difficulty in Assessing Creditworthiness
 Credit analysis requires detailed evaluation of financial statements, credit scores,
and payment history.
 Example: A wholesaler must assess whether a small retailer with fluctuating
income is a good credit risk.
D. Incorrect Credit Limits
 Granting excessive credit increases risk, while low credit limits can lose potential
sales.
 Example: A supplier sets a $50,000 credit limit for a loyal customer but later
realizes the customer could have handled $100,000 credit safely.
E. Market and Economic Uncertainty
 Economic downturns, inflation, and industry slowdowns can impact a customer's
ability to repay.
 Example: A clothing manufacturer grants credit to retailers, but a sudden economic
crisis reduces consumer spending, leading to delayed payments.
F. Ineffective Credit Policy
 Weak credit policies may result in inconsistent decisions and increased default
rates.
 Example: A company does not have a standardized credit approval process,
leading to confusion and poor credit decisions.
G. Poor Monitoring of Credit Accounts
 Some businesses fail to track outstanding invoices, leading to delayed payments.
 Example: A manufacturing firm does not follow up on overdue invoices, and after 6
months, $100,000 in payments remains uncollected.
H. Competitive Pressure to Offer Credit
  To compete with rivals, businesses may grant credit to high-risk customers.
 Example: A car dealer offers zero down payment financing to attract more buyers
but later faces loan defaults.
I. Legal and Regulatory Issues
 Businesses must comply with lending laws and consumer protection regulations
when granting credit.
 Example: A lender grants loans at high interest rates without proper
documentation, leading to legal disputes.
J. Impact on Cash Flow
 If too much credit is granted, the business may face liquidity problems.
 Example: A wholesale supplier extends credit to 80% of its customers, leading to a
shortage of cash for daily operations.
3. Example of a Credit Granting Problem in Business
Scenario: A construction materials supplier receives a request from a contractor for
$200,000 worth of materials on credit.
Problems Faced in the Decision:
1. The contractor has a low credit score (620) and past late payments.
2. Industry conditions are unstable due to an economic slowdown.
3. No guarantee of timely payment.
4. The supplier has already extended large credit amounts to other customers,
affecting cash flow.
Possible Solution:
✅ Offer a lower credit limit ($100,000) instead of $200,000.
✅ Require partial upfront payment (e.g., 50% cash, 50% credit).
✅ Set a shorter credit period (e.g., 30 days instead of 60 days).
4. Strategies to Overcome Credit Granting Problems
✅ Use a structured credit evaluation system (credit scores, financial ratios).
✅ Set realistic credit limits based on customer history.
✅ Monitor receivables regularly and send timely reminders.
✅ Use credit insurance to cover risks of bad debts.
✅ Diversify customer base to reduce dependence on a few clients.
Conclusion: Credit granting decisions involve balancing sales growth with risk
management. Businesses should use structured evaluation methods, proper monitoring,
and strong credit policies to minimize financial risks and improve cash flow.
5.9. Factoring: Meaning, definition, types & its benefits (Theory only) : Factoring is an
important financial service that helps businesses manage their cash flow by selling their
accounts receivable to a third party (factor) in exchange for immediate funds. This allows
companies to convert outstanding invoices into working capital, reducing credit risk and
improving liquidity.
1. Meaning of Factoring
 Factoring is a financial arrangement where a business sells its accounts receivables
(unpaid invoices) to a third-party financial institution (factor).
 The factor advances cash (usually 70-90% of the invoice value) to the seller and
collects the payment from the buyer (debtor) later.
 This service helps businesses improve cash flow and reduce the risk of bad debts.
 Example: A textile manufacturer sells $100,000 worth of invoices to a factoring
company, which immediately provides 80% ($80,000) upfront and pays the balance
(minus fees) once the buyers pay.
2. Definition of Factoring
According to the International Factors Group (IFG):
"Factoring is a financial transaction where a business sells its accounts receivable to a third
party (factor) at a discount in exchange for immediate cash."
According to the Reserve Bank of India (RBI):
"Factoring is a service that involves the conversion of credit sales into cash by selling
receivables to a specialized institution at a discount."
3. Types of Factoring
A. Recourse Factoring
 The seller (business) retains the risk of bad debts.
 If the customer fails to pay, the business must repurchase the unpaid invoice from
the factor.
 Example: A car parts supplier factors $50,000 in invoices but must repay if the
customers default.
B. Non-Recourse Factoring
 The factor assumes the risk of non-payment by the buyer.
 If the customer defaults, the business does not have to repay the factor.
 Example: A fashion retailer sells invoices to a non-recourse factor, ensuring zero
risk of bad debt.
C. Domestic Factoring
 Factoring transactions occur within the same country.
 The seller, buyer, and factor all belong to the same national market.
  Example: An Indian electronics manufacturer sells invoices to an Indian factoring
firm.
D. Export Factoring (International Factoring)
 Used in international trade, where the seller is in one country and the buyer in
another.
 Helps businesses reduce the risk of foreign buyers defaulting.
 Example: An Indian garment exporter sells invoices to a factoring company to
receive instant cash instead of waiting for foreign buyers to pay.
E. Advance Factoring
 The factor pays a portion of the invoice value upfront (typically 80-90%) and the
rest after collecting from the customer.
 Example: A furniture manufacturer sells invoices for $200,000 and receives
$160,000 upfront (80% advance).
F. Maturity Factoring
 The factor does not provide upfront cash but guarantees payment on a fixed date.
 Businesses use this to assure payment security.
 Example: A pharma company sells invoices but receives full payment after 90 days.
G. Invoice Discounting
 Similar to factoring but the business retains control over collections.
 The company gets a loan based on outstanding invoices, using them as collateral.
 Example: A logistics firm borrows $500,000 from a bank using unpaid invoices.
4. Benefits of Factoring
A. Improves Cash Flow
✅ Businesses get instant cash instead of waiting for customers to pay.
✅ Helps manage working capital needs efficiently.
✅ Example: A manufacturing firm uses factoring to pay salaries and buy raw materials.
B. Reduces Credit Risk
✅ In non-recourse factoring, the factor takes on the risk of customer default.
✅ Businesses do not have to worry about bad debts.
✅ Example: A startup reduces risk by using non-recourse factoring.
C. Enhances Business Growth
✅ With faster cash inflow, companies can expand operations and invest in growth.
✅ Example: A small business secures large orders by factoring invoices to meet production
costs.
D. Saves Time and Resources
✅ Factoring companies handle collections and payment follow-ups, saving administrative
effort.
✅ Businesses can focus on core operations instead of chasing payments.
✅ Example: A supplier reduces overhead costs by outsourcing collections to a factoring firm.
E. Supports Small and Medium Enterprises (SMEs)
✅ SMEs with limited credit history can use factoring as an alternative financing method.
✅ Banks may reject SME loan applications, but factoring provides them immediate liquidity.
✅ Example: A new furniture startup gets funds via factoring when banks deny loans.
F. No Additional Collateral Required
✅ Factoring is based on invoices, not company assets, making it easier for businesses to
access funds.
✅ Example: A trading company factors its $300,000 in sales invoices without pledging
property.
G. Helps in International Trade
✅ Export factoring reduces risks of foreign transactions.
✅ Businesses can expand globally without worrying about payment delays.
✅ Example: An Indian handicraft exporter ensures timely payments through export factoring.
Conclusion: Factoring is a powerful financial tool that helps businesses maintain steady
cash flow, reduce credit risks, and enhance growth. By choosing the right type of
factoring (recourse, non-recourse, export, or domestic), companies can effectively manage
receivables and optimize financial stability.