FACTORING INTRODUCTION Factoring is a type of financial service provided by the specialist organizations.

When small scale firms sell on credit basis, collection of receivable poses a problem. In that case factoring organizations play an important role in collection of debtors. Factoring involves sale of receivables to specialized firm, called factors. Factors collect receivables and also advance cash against receivables to solve the client firms liquidity problem. For providing their services, they charge interest on advance and commission for other services. In other words, factoring is an arrangement under which a financial institution (called factor) undertakes the task of collecting the book debts of its client in return for a service charge in the form of discount or rebate. The factoring institution eliminates the clients risk of bad debts by taking over the responsibility of book debts due to the client. The factoring institution advances a proportion of the value of book debts of the client immediately and the balance on maturity of book debts. DEFINITION Factoring is a service involving the purchase by a financial organization, called a factor, of receivables owned to manufacturer and distributors by their customers, with the factor assuming full credit and collection responsibilities. According to V.A. Avadhani, factoring is a service of financial nature involving the conversion of credit bills into cash. Characteristics of factoring 1. Usually the period for factoring is 90 to 150 days. Some factoring companies allow even more than 150 days. 2. Factoring is considered to be a costly source of finance compared to other sources of short term borrowings. 3. Factoring receivables is an ideal financial solution for new and emerging firms without strong financials. This is because credit worthiness is evaluated based on the financial strength of the customer (debtor). Hence these companies can leverage on the financial strength of their customers. 4. Bad debts will not be considered for factoring. 5. Credit rating is not mandatory. But the factoring companies usually carry out credit risk analysis before entering into the agreement. 6. Factoring is a method of off balance sheet financing. 7. Cost of factoring=finance cost + operating cost. Factoring cost vary according to the transaction size, financial strength of the customer etc. The cost of factoring varies from 1.5% to 3% per month depending upon the financial strength of the client's customer. 8. Indian firms offer factoring for invoices as low as Rs.1000 9. For delayed payments beyond the approved credit period, penal charge of around 1-2% per month over and above the normal cost is charged (it varies like 1% for the first month and 2% afterwards).

Customer

credit sale of goods Invoice

Client

Pays the amount (In recourse type customer pays through client)

Pays the balance amount

Submit invoice copy

Payment up to 80% initially

Factor

FUNCTIONS 1. Purchase and collection of debt 2. Sales ledger management 3. Credit investigation and undertaking of credit risk 4. Provision of finance against debts 5. Rendering consulting services TYPES OF FACTORING 1. 1) Full Servicing Factoring: This is also known as without recourse factoring service. It is the most comprehensive type of factoring arrangement offering all types of services, namely: (a) Finance, (b) Sales ledger administration, (c) Collection, (d) Debt protection, and (e) Advisory services. The most important characteristic of this type of factoring service is that it gives protection against bad debts to the client. In other words, in case the customer fails to pay, the factor will absorb the losses arising from insolvency or bankruptcy of the clients customers 2. Recourse Factoring: In such a type of factoring arrangement, the factor provides all types of facilities except debt protection. That means, in other words, the client is responsible for any bad debts arising from insolvency of the clients customers. 3. Advance factoring: In advance factoring, the factor provides an advance varying between 75-85% of the value of receivables factored and the balance is paid upon collection or on the guaranteed payment date. 4. Maturity Factoring: Under this type of factoring arrangement, except for providing finance, all other facilities are provided to the client. As far as finance is concerned, the client is paid at the end of a pre-determined date or maturity date whether or not the customers have settled their dues in respect of credit sales. 5. Disclosed or bulk factoring: In disclosed factoring, the name of the factor is disclosed in the invoice by the supplier-manufacturer of the goods asking the buyer to make payment to the

factor. The supplier may continue to bear the risk of non-payment by the buyer without passing it on to the factor. 6. Invoice Factoring or undisclosed factoring: In such type of arrangement, only finance is provided, and, hence, no other services are offered in respect of receivables. In the undisclosed factoring, the factoring arrangement is not disclosed to the customer but the customer is required to make the payment to the changed address. This is also known as non-notified factoring or confidential factoring. 7. Domestic Factoring: In the domestic factoring, the three parties involved, namely, customer(buyer), client(seller-supplier) and factor (financial intermediary) are domiciled in the same country. 8. Export/Cross-Border/International Factoring: The process of export factoring is almost similar to domestic factoring except in respect of the parties involved. There are usually four parties involved in cross-border factoring transaction. They are: exporter (client), importer (customer), export factor and import factor. 9. Agency Factoring: Under this arrangement, the facilities of finance and protection against bad debt are provided by the factor. As against this, the sales ledger administration and collection of book debts are carried out by the client himself. 10. Buyer based Factoring: In most case, the factor is acting as an agent of the seller. But under this type, the buyer approaches a factor to discount his bills. Thus the initiative for factoring comes from the buyer end. 11. Seller based Factoring:

Benefits of factoring: 1. Financial Service Many of the manufacturers and traders find their working capital being locked up in the form of trade debts. This has been a great handicap to the small and medium scale manufacturers. Many business concerns fail more as a result of inadequate cash flow than anything else. The major benefit of the factoring service is that the clients will be able to convert their trade debts into cash up to 80% immediately as soon as the credit sales are over. The greatest advantage is that factoring assures immediate cash flow. When the cash position improves, the client is able to make his purchases on cash basis and thus, he can avail of cash discount facilities also.

2. Collection services Collection of debts is another problematic area for many concerns. Collection of debts becomes an important internal credit management and it requires more and more time. Delay in collection process often leads to delay in production and supplies. Now, this collection work is completely taken up by the factoring organisation, leaving the client to concentrate on production alone. The cost of collection is also cut down as a result of the professional expertise of a factor. 3. Credit risk service Bad debts eat away the profits of a concern and in some cases, it may lead to the closure of a business. once the factoring relationship is established, the client need not bother about the loss due to bad debts. The factor assumes the risk of default in payment by customers and thus, the client is assured of complete realisation of his book debts. Even if the customer fails to pay the debt, it becomes the responsibility of the factor to pay that amount to the client. It is the greatest advantage of factoring. 4. expertise sales ledger management service The success of any organisation depends upon the efficiency with which the sales ledger is managed. It requires a specialised knowledge which the client may not possess. The client can receive services like maintenance of accounting records, monthly sales analysis, overdue invoice analysis and customer payment statement from the factor. It becomes the factors responsibility to take care of all the functions relating to the maintenance of sales ledger. 5. Consultancy Service Factors are professionals in offering management services like consultancy. They collect information regarding the credit worthiness of the customers of their clients, ascertain their track record, quality of portfolio turnover, average size of inventory etc., and pass on the same to their clients. It helps the clients avoid poor quality and risky customers. 6. Economy in Servicing Factors are able to render very economic service to their clients. Their service charges are also reasonable. Factoring is a cheap source of finance to the client because the interest rate is charged only on the amount actually provided to the client. Clients are able to get factoring services at economic rates. 7. Trade Benefits Availability of ready cash against bills enables the supplier to negotiate better prices for the inputs and also offer finer terms to customers. It ensures a steady flow of inputs on the one hand and better market prospects on the other. Factoring enables the supplier to concentrate on production and materials management without bothering about the financial management. Factoring enables clients to offer longer credit facilities to their customers and thus to attract more business.

8. Miscellaneous Service Factors are able to computerize their operations fully. They are able to render prompt service at reasonable rates. They also build bigger credit library of debtors by means of collecting information about new debtors. 9. Off-Balance Sheet Financing When the factor purchases the book debts of the client, these debts no longer exist on the current assets side of the balance sheet. It leads to reduction in debts and less collection problems. The client can utilize the money so received to reduce his current liabilities. It means an improved current ratio. Disadvantages of Factoring 1) Image of the client may suffer as engaging a factoring agency is not considered a good sign of efficient management. 2) Factoring may not be of much use where companies or agents have one time sales with the customers. 3) Factoring increases cost of finance and thus cost of running the business. 4) If the client has cheaper means of finance and credit (where goods are sold against advance payment), factoring may not be useful.

FACTORING IN INDIA In Indian context, factoring is being viewed as a source of short-term finance that can offer useful services specially to the supplier. SBI is the first factoring company to be set up in India. It was incorporated in February 1991 and it commenced its business operations from April 1991. A SBI factor, a subsidiary of the SBI, is one of the leading factoring companies in India. Factoring companies: SBI Factors and Commercial Services Pvt. Ltd March 1991 with paid up of Rs 25 crores. Can bank Factors Limited August 1991 with paid up of Rs 10 crores was contributed by Canara Bank, Andhra Bank and SIDBI Fair Growth Factors First Private Sector Company in April 1992 with paid up of Rs 5 crores

Foremost Factors Limited 1997 Joint venture between the Mohan Exports and the Nations Bank Overseas Corporation(USA), 20th Century Finance Corporation and the ICDs group.

Global Trade Finance Limited -September 2001, as a joint venture promoted by Export Import Bank of India (Exim Bank); West LB, Germany; and IFC, Washington (the private sector arm of World Bank).

DIFFERENCE BETWEEN FACTORING AND FORFAITING FACTORING FORFAITING

1. Suitable for ongoing open account sales, not backed by LC or accepted bills or exchange. 2. Usually provides financing for short-term credit period of upto 180 days. 1. Oriented towards single transactions backed by LC or bank guarantee. 2. Financing is usually for medium to long-term credit periods from 180 days upto 7 years though shorterm credit of 30180 days is also available for large transactions. 3. Seller need not route or commit other business to the forfaiter. Deals are concluded transaction-wise. 4. Forfaiters responsibility extends to collection of forfeited debt only. Existing financing lines remains unaffected. 5. Single discount charges is applied which depend on guaranteeing bank and country risk, credit period involved and currency of debt. Only additional charges is commitment fee, if firm commitment is required prior to draw down during delivery period. 6. Usually available for export receivables only denominated in any freely convertible currency. 7. It is always without recourse and essentially a financing product. 8. Transactions should be of a minimum value of USD 250,000. 9. Forfaiting will accept only clean documentation in conformity with all regulations in the exporting/importing countries

3. Requires a continuous arrangements between factor and client, whereby all sales are routed through the factor. 4. Factor assumes responsibility for collection, helps client to reduce his own overheads. 5. Separate charges are applied for : financing collection administration credit protection and provision of information. 6. Service is available for domestic and export receivables. 7. Financing can be with or without recourse; the credit protection collection and administration services may also be provided without financing. 8. Usually no restriction on minimum size of transactions that can be covered by factoring 9. Factor can assist with completing import formalities in the buyers country and provide ongoing contract with buyers.