What is factoring?

Do cash flow struggles leave you wondering how your business will grow and thrive?
If so, you are definitely not alone. No matter the industry or the size of the company,
maintaining steady cash flow is a common challenge among business owners. What
if there was a solution that provided you with the working capital you seek using an
existing asset? Factoring, or accounts receivable finance, is that solution.
Many have heard about factoring, but how do you know that factoring is right for you? Do your
customers require extended terms making it difficult for you to wait for payment? Do you have difficulty
filling orders because your suppliers require payment before you receive payment from your customers?
Are you borrowing money from friends or family or using personal savings to keep your business afloat?
Do you worry about how you will meet your current obligations-rent, insurance, payroll? If you
answered yes to any of these questions, then factoring can be the miracle cure for what is ailing your
business.

Factoring services have become quite popular all over the world now, with more than 900 companies
offering these services. Factoring is a contract like any other sale purchase agreement regulated under
the law of contract.

Meaning: Like securitisation factoring also is a financial innovation. Factoring provides resources to
finance receivables. Factoring is a financial transaction whereby a business sells its account receivables
to a third party (called a factor) at a discount in exchange of immediate money with which to finance
continued business.

Definition: Peter M. Discos:- "a continuing legal relationship between a financial institution (the factor)
and a business concern (the client) selling goods or providing services to trade customers, whereby the
factor purchases the clients’ book debts, either with or without recourse to the client, and in relation
thereto, controls the credit extended to customers, and administers the sales ledger".

Who is a factor?

A factor is a financial institution that specializes in purchasing receivables from business firms. Factor is
responsible for collection of receivables and on the event of non payment by customers bears the risk of
bad debt and losses.

PARTIES INVOLVED IN FACTORING TRANSACTION

Basically there are 3 parties involved in the process of factoring transaction:

a. Seller or supplier
b. Buyer or customer
c. Factor

PROCESS INVOLVED IN FACTORING

 Client concludes a credit sale with a customer.

  Client sells the customer's account to the Factor and notifies the customer.
 Factor makes part payment (advance) against account purchased, after adjusting for
commission and interest on the advance.
 Factor maintains the customer's account and follows up for payment.
 Customer remits the amount due to the Factor.
 Factor makes the final payment to the Client when the account is collected or on the guaranteed
payment date.

Scope of Factoring:

1. Administration of Sales Ledger: The factor assumes the entire responsibility of administering sales
ledger. The factor maintains sales ledger in respect of each client.

2. Collection of Receivables: The factor helps the client in adopting better credit control policy. The main
services of a factor are to collect the receivables on behalf of the client and to relieve him from all the
botherations/ problems associated with the collection.

3. Provision of Finance: Finance, which is the lifeblood of a business, is made available easily by the
factor to the client.

4. Protection Against Risk: This service is provided where the debts are factored without recourse. The
factor fixes the credit limits (i.e. the limit up to which the client can sell goods to customers) in respect
of approved customers.

5. Advisory Services: These services arise out of the close relationship between a factor and a client.
Since the factors have better knowledge and wide experience in field of finance, and possess extensive
credit information about customer’s standing, they provide various advisory services.

6. Credit Management: The factor in consultation with the client fixes credit limits for approved
customers.

HOW FACTORING IMPROVES YOUR CASH FLOW?

Your company delivers a good or service to your customer. Your customer will require terms to allow for
processing of your invoice. Companies typically have payment terms of between 30 and 90 days,
although terms vary from customer to customer. What happens during the time your customer is
processing payment for your invoices? While you wait for payment, you may experience challenges with
paying bills, making payroll, paying vendors, purchasing fuel, and other common business
expenses.Now, rather than you waiting for payment, your factoring company collects payment from
your customers. In the meantime, you continue to factor your invoices and receive your funds quickly.
The burden has been lifted off your shoulders

But, when you factor your invoices, the gaps in your cash flow disappear. You get the funds you need
immediately, so that you do not have to worry about when your payments will arrive. You already have
the working capital you need to meet all your obligations.

ADVANTAGES

1. Improve the current ratio- Factoring helps in improving the current ratio. The improvement in
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. Immediate cash inflows- This type of finance shortens the cash collection cycle. It provides
swift realization of cash by selling the receivables to a factor. Availability of liquid cash
sometimes becomes a deciding factor for grabbing an opportunity or losing it. The cash boost
provided by factoring is readily available for capital expenditures, securing a new order, or
meeting an unforeseen condition.
3. Evasion of Bad debts - In the case of bad debts, the loss is borne by the factor. Hence, the seller
is under no obligation to the factor once it sells off its receivables.
4. Attention towards business growth - By selling off invoices, business managers can feel stress-
free with the task of collection from the customers. Resources employed in the receivables
department can be directed toward business operations, financial planning, and future growth.
5. Speedy arrangement of finance- Factors provide funds more rapidly than banking
companies. Factoring companies offer a process of factoring that is a quicker application, lesser
documentation, and swifter realization of funds compared to other financial institutions.

DISADVANTAGES

1. Reduction in profit- The factor deducts a certain discount from the value of accounts receivable
as fees for the services offered. Moreover, in some instances, the factor also charges interest on
the advance made. Consequently, profit of an entity is reduced by a significant margin.
2. Reliability of customer’s credit- The factor assesses and evaluates the credit wellness of the
party who owes bills receivables. This is a critical factor that is outside the control of the seller. A
factor may refuse to extend advances due to the poor credit ratings of the concerned party.
3. Expensive- A Factor will charge your business for the length of time that an invoice is unpaid,
they will charge some flat fees, and there will be a holdback reserve policy which in total makes
it expensive.
4. Possibility of Business failure- If mismanaged, it can result in business failure.
5. Possibility of Unpaid invoices- There’s no certainty the invoice factoring company will
successfully collect on your unpaid invoices.

TYPES OF FACTORING SERVICES

1. RECOURSE FACTORING - Recourse is a type of Factoring that happens when an entity has to
sell the invoices to the factor with the condition that if an invoice is unpaid or paid late then
 the Company will have to absorb the costs not the factor and buy back the invoice. For
example, assume that a factor has advanced an amount of Rs.2 lakh against a receivable of
Rs.3 lakh which turns out to be irrecoverable. Under a recourse factoring arrangement, the
factor can recover the sum of Rs.2 lakh from the entity. It’s a cheaper form of finance than
non-recourse factoring. Advance fees is high because the seller bears the risk whereas factor
fees is low in this type of factoring.
2. NON-RECOURSE FACTORING - The agreement with non-recourse factoring is that,
within certain conditions, if the payments are late or unpaid then the Factor absorbs
the costs, the company does not have to worry about debt created by unpaid
invoices. It can be a risk free form of finance. It is beneficial for companies whose
main business comes from a small number of customers. Advance fees is low
because the factoring company has to bear high risk whereas factor fees is high.
3. DISCLOSED FACTORING - In disclosed factoring, the name of the factor is mentioned in the
invoice by the supplier telling the buyer to make payment to the factor on the due date.
Disclosed type can either be recourse or non-recourse.
4. 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 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.
5. ADVANCE FACTORING - Factor pays a pre-specified portion, ranging between 75% to 90% of
the factored receivables in advance. Balance being paid upon collection on the guaranteed
payment date. Seller has to pay interest (discount) on the advance between the date of such
payment. The rate of interest/discount is determined on the basis of credit worthiness of
the client. Date of actual collection from the customer determined on the basis of the
prevailing term rate, the financial standing of the client and the volume of the turnover.
6. MATURE FACTORING - It is an arrangement where the factor provides the client with
payment of the account receivables at the end of collection period or on the day of
collection of receivables, whichever is earlier. Guaranteed payment date is usually fixed
taking into account previous collection experience of the Client. There is no risk for the
Factor.

FACTOR CHARGES
1. FACTOR CHARGES- Finance charge is computed on the prepayment outstanding in the
client's account at monthly intervals. Finance charges are only for financing that has
been availed. These charges are similar to the interest levied on the cash credit facilities
in a bank.
2. SERVICE FEE: Service charge is a nominal charge levied at monthly intervals to cover the
cost of services, namely, collection, sales ledger management, and periodical MIS
reports. The service fee is determined on the basis of criteria such as the gross sales
value, number of customers, the number of invoices and credit notes, and the degree of
credit risk represented by the customers or the transaction.
Both these charges taken together compare very favourably with the interest rates
charged by banks and financial institutions for short-term borrowings.
 FACTORING AND THE ECONOMY
The economic significance of factoring stems from the stabilizing influence it will have
on industry and trade. The immediate impact of factoring will be the promotion of
efficiency and profitability of the small and medium sized industrial units, which cannot
go to capital market for their capital requirements for growth or diversification,
factoring could also serve as a spring board for planed growth. Further, Factoring will
also promote a prompt payment culture among industrial and trading units by
facilitating the overall acceleration of the receivables turnover. The impact of this
accelerated receivables turnover will be better return on capital because of the
facilitation of greater volume of business on the same amount of capital or the same
amount of business on smaller amount of capital. Thus, such a prompt payment culture
prompted by factoring among industrial land trading units and the resultant overall
accelerated receivables turnover will ultimately have a multiplier effect on production,
employment and economic growth.

PROSPECTS OF FACTORING IN INDIA

 Kalyana Sundaram Committee recommended introduction of factoring in 1989.
 Banking Regulation Act, 1949 was amended in 1991 for banks setting up
factoring services.
 RBI has permitted banks to undertake factoring services through subsidiaries.
 SBI & Canara bank have set up their factoring subsidiaries in the year 1991.
The government introduced the Factoring Regulation Act 2011 to establish a cohesive
legal framework that governs all factoring transactions. The aim was to facilitate access
to cost-efficient working capital cash flows.

NEED OF FACTORING IN INDIA

 There is sufficient scope for the introduction of factoring services in India, which
would be complementary to the services provided by banks.
 The introduction of export factoring services in India would provide an
additional facility to exporters.
 With a view to attaining a balanced dispersal of risks, factors should offer their
services to all industries and all sectors of the economy.

FACTORING COMPANIES IN INDIA

 Canbank Factors Limited

 SBI Factors and Commercial Services Pvt. Ltd.
 The Hongkong and Shanghai Banking Corporation Ltd.
 Foremost Factors Limited
 Global Trade Finance Limited
 Export Credit Guarantee Corporation of India Ltd.
 Small Industries Development Bank of India (SIDBI)