Factoring and Forfaiting

Factoring

• Factoring is a financial service in which a business sells its receivables from

customers/debtors to a third party at a discount in order to raise funds.

• A business makes the sale of goods or services and generates invoices for
the same. The business then sells all its invoices to a third party called the
factor. The factor pays the seller, after deducting some discount on the
invoice value.

• The rate of discount in factoring ranges from 2 to 6 percent. However, the

factor does not make the payment of all invoices immediately to the seller.
Rather, it pays only up to 80 percent of the invoice value after deducting the
discount.

• The remaining 20 percent of the invoice value is paid after the factor
receives the payments from the seller’s customers. It is called factor
reserve.
Parties involved in factoring

1. The Factor

The factor is the party who purchases the invoices. Factors make money
by collecting the full amount of the unpaid invoices. They will purchase
the unpaid invoice at a lower amount than their “face value.”

2) The Seller

The seller is the party who sells the invoices. Sellers consist of
businesses that allow customers or clients to pay after their products
have been delivered or their services completed.

3) The customer

The customer is the party who owes money to the business or seller.
Debtors are essentially customers or clients. After making a purchase,
they will receive an invoice for the purchase amount. Debtors will initially
owe this money to the business from which they purchased the product
or service. If the business sells some of its invoices to a factor, though,
the debtors will owe this money to the factor.
Services in factoring

1. Invoice Financing: Provides immediate cash by purchasing

invoices.

2. Credit Control: Manages the collection of payments from

customers.

3. Credit Insurance: Protects against non-payment of invoices.

4. Accounts Receivable Management: Handles the entire accounts

receivable process.
Steps involved in factoring

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.
Advantages of Factoring:

1. Immediate cash flow/liquidity:

Under the factoring arrangement, the factor pays up to 80% of receivables

within one-two working day of presentation of the invoice. This substantially
reduces the average receivable days, leading to improved liquidity and efficient
working capital management.

2. No Need for Collateral:

Most factoring companies don’t need collateral as the receivables, and the
buyers are duly audited and the financial institution assumes the risk.

3. Focus on Core Activities:

Factoring saves time and the cost of collecting customers’ receivables. This
makes it a good solution for small businesses. The factor provides all services
related to sales ledger management, collection of account receivables, credit
control and protection, etc., enabling the company to concentrate on its core
competencies more efficiently.
Advantages of Factoring:

4. A sale, not a loan:

Factoring is not a loan and does not create any liability on the balance
sheet. This is in stark contrast to a bill discounting service where the
discounted bills are simply used as collateral against the loans.

5. Advisory serviccs

Factor offers various advisory services to its clients, including credit

assessment for overseas buyers. This helps the exporter to learn more
about the customer and to negotiate better terms and conditions for the
business. In cases where the factor rejects the application due to a poor
record or risky importer, the factor will keep the exporter informed
about the dangerous trade.

This helps the exporter avoid such transactions and engage only with
verified and legitimate buyers. Some factors also have experts on their
team who advise exporters on the finer technical aspects of a client’s
business.
Advantages of Factoring:

6. Protection from Bad Debts:

The factor assumes the risk of bad debts. So, the exporter can focus on growing
the business with the unlocked capital instead of worrying about getting paid.

7. Cost Competitive:

Since factoring is a very competitive industry, costs are usually reasonable,

making it a cost-effective way of managing the sales ledger functions.
Disadvantages of factoring

1. High commissions

Factoring companies usually charge a high commission for each operation

that is always carried out based on the credit requested.. They can also be
charged other types of commissions by credit maturity or by different
efforts that the entity has to carry out, what is the example of the solvency
study.

2. Image of the company

In the eyes of a client the fact that a factoring company claims invoices
can affect the trust in the relationship between the two companies. A
company must have a stable image in the eyes of its suppliers, and sending
a factoring company to deal with the collection can create insecurities
about the real state of the company's economy and affect the relationship.
But how everything has a solution, and that is that to avoid that we can
resort to Secret Factoring.
Disadvantages of factoring

3. Higher Interest Rate:

The advance provided is generally available at a higher interest cost than

the usual rate.

4. Involvement of Third Party:

The factor is the third party to the customer who may not feel comfortable
while dealing with it.

5. Small businesses

Factoring may not be suitable for small businesses. Even if it suitable it can
become unviable,

6. Competency of sellers

Factoring shows how incompetent the existing sales team of a company is. It
may not be useful in all situations. Only if the sales team is not able to
collect, should factoring be resorted to.
Disadvantages of factoring

7. No loans against debtors/receivable balances

A business uses its receivables to get financing. But in the case of

factoring the receivables or debtors do not appear in its balance sheet
and hence working capital loans cannot be obtained.
Types of factoring in India

1. Recourse Factoring

Under recourse factoring, the factor does not assume the credit risk or the risk
of default by the customer. Credit risk is the risk of customers defaulting on
their payment obligation. If the customer does not pay the dues on the due
date, the factor will seek recourse against the client and exercise the right to
recover the amount from the client. The factor provides sales ledger
management services; however, the client bears the credit risk.

2. Non-recourse Factoring

In non-recourse factoring, the factor bears the credit risk in addition to

providing other services. Thus, even if the customer defaults on the due date,
the factor cannot claim the amount back from the client. Naturally, the fees
charged for non-recourse factoring services are higher than those for recourse
factoring as they involve the cost of bearing the risk of non-payment by the
customer.
Types of factoring in India

3. Full-Service Factoring

Known as full factoring or old line factoring . Here the factor performs a full
range of services, including maintaining a sales ledger, sending regular
statements of accounts to the client, collection of receivables, and credit control
- gauging the creditworthiness of the customer, deciding credit limits and credit
insurance for bearing the credit risk. This type of factoring charges the highest
rates for services. Beyond the factoring charges, the administrative cost of
factoring ranges between 0.5% to 2.5% of receivables.

4. Domestic factoring

Domestic factoring involves three parties - the client (the seller), the customer
(the buyer) and the factor (the financial entity). All the parties are located in the
same region. Domestic factoring is also far easier to operate and execute since
cultural, legal and trade barriers between the trading parties are more or less
similar.
Types of factoring in India

5. International/export factoring

In export factoring there may also be an additional party - the import factor
(factor located in the customer’s region) in addition to the client, the
customer, and the export factor (in the client’s region). The import factor is
responsible for services like determining creditworthiness and credit limit
for the customer and collecting money from the customer on the due date
and remitting it to the export factor.

6. Spot Factoring

Spot factoring is when the client and the factor enter into a factoring
arrangement for one single specific transaction.

7. Regular factoring

Under the factoring arrangement, the factor and the client have an ongoing
relationship by virtue of an agreement. Usually, a factor prefers regular
factoring and perceives it to be less risky than a spot factoring
arrangement.
Types of factoring in India

8. Maturity factoring

Maturity factoring is also known as collection factoring. Under this type of

factoring, the factor collects dues from the customer. It passes the agreed upon
share to the client usually on the maturity date of each month's sales invoices.

9. Advance factoring

factor pays 75% - 90% (as per the contractual agreement) of factored
receivables in advance to the client. This is done within a couple of working
days from the presentation of the invoice to the factor.

The balance amount is paid on the guaranteed payment date on the realization
of money from the customers, as per the contract.
Types of international factoring

Single factoring • Under this system, the factoring companies in the exporting and
system importing countries sign a special agreement explaining the terms of
factoring. The agreement stipulates that only one factoring agency
would perform all the functions.

Two factoring • Under this system, the transaction involves four parties; exporter,
system importer, import factor in importer’s country, and export factor in
exporter’s country. This is the most used factoring

Direct export • Under this system, only the export factor is involved. The export
factoring factor takes care of all the functions. Such a system helps in lowering
the cost.

Direct import • Under this, the seller transacts directly with the factor in the
factoring importer’s countries. The import factor carries all the functions.
Challenges to factoring in India
Lack of • In India factoring has not developed because there are few factoring
knowledge firms and people are not aware of what is factoring services. The firms
doing factoring have also not promoted their business well and so people
are not aware of the role of factors in the economy.
Better • In India banks provide better and multiple services to customers. Ther
services from cost of providing services is higher as they have multiple customers and
banks can provide services at economical rates.Whereas the cost of providing
loans and assistance by factoring companies are higher due to higher
operational cost, unsecured facility and hence factoring has not
developed.
Credit • In India factoring companies do not offer credit insurance facility wherein
insurance they mitigate the risk of non recoveries from customers. Hence factoring
facility is not popular in India
Access to • Factors cannot approach debt recovery tribunals if the customers of their
debt clients are defaulters. This makes the recovery of dues of customers
recovery solely a task of the factor and other modes of recovery are not available
platforms
Fake bils • In the textile, pharma and Iron & Steel industry factors suffer losses due
to fake bills submitted by clients for sale of receivables to the factor. This
has made factoring an unviable business.
Forfaiting

• Forfaiting is a method of trade finance that allows exporters to obtain cash by

selling their medium and long-term foreign accounts receivable at a discount to a
forfeiter.

• Forfaiting is a method of obtaining medium-term funds for a business involved in

international trade. The process consists of a company engaged in exporting the
capital goods, selling foreign accounts receivables like promissory notes or bills of
exchange, and immediately receiving the financing. The party external to the
international transaction who provides the funds is called the forfaiter.

Parties involved in forfaiting

• Exporter
• Exporter’s bank
• Importer
• Importer’s bank
• Forfaiter
Steps in forfaiting

Step 1: The exporter must zero in on the forfaiter with whom he wants to finance the
transaction. A forfaiting agreement is entered into once the export is selected.

Step 2: An agreement is made between the two parties--importer and exporter.

Step 3: The importer secures a guarantee from his local bank to facilitate the trade.

Step 4: The exporter ships the package of goods.

Step 5: The exporter submits the required documents to the forfaiter.

Step 6: The forfaiter pays the exporter a sum as decided in the agreement. By doing so, he
obtains complete control over the shipment documents.

Step 7: At maturity, the forfaiter presents the documents to the importer's bank.

Step 8: The importer’s bank collects the payment from the importer.

Step 9: Payments received by the importer's bank are routed to the forfaiter.
Advantages of forfaiting

1. Immediate Cash Flow: Forfaiting provides cash flow that enables

exporters to get money for his business.

2. Risk Mitigation: The forfaiter assumes credit risk, eliminating the need for
the exporter to spend time and resources on collecting payments from
buyers.

3. Protection against bad debts: Forfaiting offers protection against bad

debts risk by ensuring that payment is made to the exporter regardless of
whether the importer has ability to pay or whether he will be able to
recover his dues from the importer on the due date.

4. Foreign Exchange Rate fluctuations: The forfaiter gives money thee

exporter upon submission of documents. The exporter is protected
against exchange rate fluctuations between the sale date and the agreed
date on which the importer will be making payment.

5. Flexible Financing: Forfaiting offers a range of financing options tailored

to suit the specific needs of different industries and transactions.
Disadvantages of forfaiting

1. Not suitable for small companies Forfaiting is generally suitable for large
volume transactions. It is not suitable for small companies as they find
forfating costly.

2. High Transaction Costs: Forfaiting incurs various fees and expenditures,

including discount fees, handling charges, and administrative expenses. These
charges might be
Costly for and exporter as compared to other means of finance.

3. Limited Market Reach: Forfaiting has a limited market reach because it is

mainly employed in international trade, focused on transactions between
exporters and importers from various nations.

4. Strict Documentation
Forfaiting transactions require various documents, including invoices, bills of
exchange, and other legal instruments. The documentation procedure is very
strict and detailed.

5. Limited Flexibility: Once export receivables are forfaited, the exporter's debt
management options are limited. Other debt management options although
cheaper cannot be entered into by an exporter once he goes for forfaiting.
 Distinction between factoring and forfaiting

Factoring Forfaiting
Factoring is a financial service in which a Forfaiting is a method of trade finance
business sells its receivables from that allows exporters to obtain cash by
customers/debtors to a third party at a selling their medium and long-term
discount in order to raise funds. foreign accounts receivable at a discount
to a forfeiter.

The seller bears the cost of factoring The overseas importer bears the cost of
forfaiting
Involves receivables on short term period Involves receivables on medium and long
term period
The factor pays initially around 80% of The forfaiting firm pays 100% of invoice
the value of invoice to the overseas exporter
Suitable for local or domestic trade Suitable for international trade
All risks will be with the seller All risks will be with the overseas
importer
Factoring can be with or without recourse Forfating is always done without recourse
The parties involved are seller, buyer and The parties involved are exporter,
Problems on factoring

Type A – Finding out the net advance to be paid by the factor to a seller

Factor commission is to be calculated on gross receivables as factor will be collecting

receivables on behalf of seller.

Discount/interest payable to factor is to be calculated on net receivables by assuming 360

days.

Net advance by factor = gross advance less discount/interest less factor commission

1. Aarti Industries Ltd has a sales turnover of Rs 25 lakhs and an accounts receivable of Rs
2 lakhs. The company is contemplating hiring the services of a factor. The factor will give
an advance of 80% of the o/s receivables and charge interest of 15% p.a. for 90 days.
Factor commission will be 2%. Find the net advance available to client by the factor

2. Vrindavan Silks Ltd has a sales turnover of Rs 49 lakhs and o/s receivables of Rs
3,00,000. A factor has offered his services to the company to collect the receivables. It
has decided to fund an advance of 80% and will charge interest of 18% p.a. for 90 days.
Factor commission will be 2%. By engaging the factor the company will save annually Rs
1,500. Find the net factor advance to the client.
Problems on factoring

Type B – Finding out the advance by factor to the seller and the cost of factoring
where there are savings

Factor commission is to be calculated on gross receivables

Discount/interest payable to factor is to be calculated on net receivables by assuming 360

days.

Interest/discount % = discount/interest worked out annually less savings x 100

(factor advance less commission less interest)

1. Receivables 1,00,000, 80% advance by factor. Factor commission is 2% and interest is

18% for 90 days. Savings due to engagement of factor is 5,000 Rs. Calculate the cost of
factoring and funds that will be given to customer by the factor.

2. Receivables 2,00,000, 80% advance by factor. Factor commission is 2% and interest is

16% for 90 days. Savings due to engagement of factor is 3,000 Rs. Calculate the cost of
factoring and funds that will be given to customer by the factor.
Type C – Calculation of effective cost of factoring where there is no savings

Discount/interest % = discount/interest x 100

(advance less commission less interest)

Effective cost of interest = {(1 + interest)4 -1} x 100

100)

1. Ruchi Soya Ltd has agreed to sell its receivables to a factor M/s Rajesh & Company who
has agreed to give and advance of Rs 1 lakhs against receivables. The factoring firm will pay
80% advance. The advance will be for a period of 3 months and will carry an interest of 15%
p.a. factoring commission will be 2% of the value of receivables factored.

a) Compute the amount actually made available by M/s Rajesh & Company to Ruchi Soya
Ltd.
b) Compute the effective cost of funds made available to Ruchi Soya Ltd.

2. Dastur & Company has agreed to sell its receivables to a factor M/s Bimjal Sons who has
agreed to give and advance of Rs 1 lakhs against receivables. The factoring firm will pay
80% advance. The advance will be for a period of 3 months and will carry an interest of 14%
p.a. factoring commission will be 2% of the value of receivables factored.

a) Compute the amount actually made available by M/s Rajesh & Company to Ruchi Soya
Type C – Calculation of effective cost of factoring where there is no savings

3. Under a factoring agreement, Darpan Ltd a factor has agreed to advance a sum of Rs
20 lakhs against receivables purchased from Sesa Goa Ltd.

The factor will pay an advance of 75% of the value of factored receivables and for
guaranteeing payment after three months from the date of purchasing the receivables.

The advance carries 15% interest compounded quarterly and factoring commission of 1%
of the value of factored receivables. Both the interest and the commission are collected
upfront.

a) Compute the amount actually made available by Darpan Ltd to Sesa Goa Ltd.

b) Calculate the cost of funds made available to Darpan Ltd.

Type C – Calculation of effective cost of factoring where there is no savings

4. Under a factoring agreement, D Ltd a factor has agreed to advance a sum of Rs 14

lakhs against receivables purchased from S. The factor will pay an advance of 75% of the
value of factored receivables and for guaranteeing payment after three months from the
date of purchasing the receivables.

The advance carries 15% interest compounded quarterly and factoring commission of 3%
of the value of factored receivables. Both the interest and the commission are collected
upfront.

a) Compute the amount actually made available by D Ltd to S Ltd.

b) Calculate the cost of funds made available to D Ltd.

c) Assume that interest is collected in arrears and commission is collected in advance

calculate the effective cost of funds.

Discount/interest % = discount/interest x 100

(advance less commission)

Effective cost of interest = {(1 + interest)4 -1} x 100

Type C – Calculation of effective cost of factoring where there is no savings

5. Under a factoring agreement, All Bright Ltd a factor has agreed to advance a sum of Rs
50 lakhs against receivables purchased from ITC Ltd.

The factor will pay an advance of 85% of the value of factored receivables and for
guaranteeing payment after three months from the date of purchasing the receivables.

The advance carries 12% interest compounded quarterly and factoring commission of 2%
of the value of factored receivables. Both the interest and the commission are collected
upfront.

a) Compute the amount actually made available by All Bright Ltd to ITC Ltd.

b) Calculate the cost of funds made available to ITC Ltd.

c) Assume that interest is collected in arrears and commission is collected in advance

calculate the effective cost of funds.

Discount/interest % = discount/interest x 100

(advance less commission)

Effective cost of interest = {(1 + interest)4 -1} x 100

Type C – Calculation of effective cost of factoring where there is no
savings

6. Under an advance factoring arrangement Factors Ltd has agreed to advance a

sum of Rs 20 lakhs to Bharat Forge Ltd.

The factor will advance 80% of o/s receivables for 3 months at 16% interest per
annum compounded quarterly and the factoring commission will be 1.5% of the
value of factored receivables. Both the commission and interest are collected
upfront.

a) Compute the amount actually made available to Bharat Forge Ltd.

b) Calculate the effective cost of funds made available to Bharat Forge Ltd

c) Assume the interest is collected in arrears and the commission is collected in

advance calculate the effective cost of funds to Bharat Forge Ltd.

Discount/interest % = discount/interest x 100

(advance less commission)

Effective cost of interest = {(1 + interest)4 -1} x 100

100)
Type C – Calculation of effective cost of factoring where there is no savings

7. Under an advance factoring arrangement Kamal Ltd has agreed to advance a sum of Rs
72 lakhs to Bimal Ltd.

The factor will advance 80% of o/s receivables for 3 months at 15% interest per annum
compounded quarterly and the factoring commission will be 1.5% of the value of factored
receivables. Both the commission and interest are collected upfront.

a) Compute the amount actually made available to Bimal Ltd.

b) Calculate the effective cost of funds made available to Bimal Ltd

c) Assume the interest is collected in arrears and the commission is collected in advance
calculate the effective cost of funds to Bimal Forge Ltd.

Discount/interest % = discount/interest x 100

(advance less commission)

Effective cost of interest = {(1 + interest)4 -1} x 100

100)
Type D – Calculation of advance to be paid by a factor to a seller when there is
withholding of advance.

Factoring advance = Receivables – (factor’s commission) –(factor reserve) = XX –

(interest on advances kept as factor reserve calculated on XX figure )

1. The details of arrangement between Madhusudhan Industries Ltd with a factor is as under

Particulars Amount
Total sales 10,00,000
Days in a year 360
Collection period 90 days
Bad debts 1.5%
Collection costs of bad debts Rs 60,000
by the company
Factors commission 2%
Interest on advances on 18%
receivables
Factor withholding advances
as reserve on