CHAPTER I

INTRODUCTION

The origin of factoring goes back to ancient Rome where rich

manufacturer and merchants used a mercantile agent or factor to administer the
sales of their merchandise. The use of the Factor/Agent grew throughout the
middle ages. During the period of colonization by European countries from the
sixteenth century onwards, exporters of consumer goods from Europe sought
the help of these mercantile agents or factor to promote their trade. The concept
spread across the Atlantic and grew rapidly in the United States, as there was
significant demand for European merchandise.

Finance is the lifeblood and controlling nerve centre of a business. It is a

well known fact that the key to any business success is to effectively manage
its Working Capital. The need for Working Capital arises due to the time gap
between Production and realization of cash and sales, which in turn makes the
business concern unable to meet the short term liabilities in time. To remove
cash flow deficiencies. Factoring comes to play significant role in managing
and financing of debts arising out of Credit Sales. Factoring unlike a
Traditional Bank Loan, does not add any additional to the Balance sheet of the
concern. It provides the business unit with immediate cash on Purchase of debt
invoices which in turn enables it to meet its pay roll. With cash flows better
managed, Entrepreneurs can concentrate on growing their business rather than
worrying about finding cash.

The markets have graduated from being a seller's paradise to a buyer's

domain. This, in turn, has greatly affected the capacity of the businesses to
demand timely payment within a short period of time. In fact, some firms have
now resorted to giving liberal trade credit to boost the sales leading to a sharp
increase in their accounts receivables. This has put tremendous pressure on the
working capital requirements of small and medium sized firms. They have
thus, started to look at some non-traditional forms of financing like
FACTORING.

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 Factoring, basically involves transfer of the collection of receivables and
the related bookkeeping functions from the firm to a financial intermediary
called the Factor. In addition, the factor often extends a line of credit against
the receivables of the firm. Thus, factoring provides the firm with a source of
financing its Receivables and facilitates the process of collecting the
receivables.

Thus, factoring is a method of financing whereby a company sells its

trade debts at a discount to a financial institution. Factor is a collection and
finance service designed to improve the cash flow position by turning the credit
invoices in to ready cash. As per this arrangement, the factor purchases the
clients trade debts including accounts receivables either with or without
recourse to the client, and thus, exercises control over the credit extended to the
customers and administers the sales ledger of his client.

The client is immediately paid 80% of the trade debts taken over and
when the trade customers repay their dues, the factor will make the remaining
20% payment.

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1.1 FACTORING – MEANING
The word 'Factor' is derived from a Latin word 'Facere' which means 'to
get things done'. Factoring is a "continuing arrangement "between a financial
institution (the factor) and a business concern (the client) selling goods or
services to trade customers (the customer) whereby the factor purchases the
client's accounts receivables/book debts either with or without recourse to the
client and in relation there to controls the credit extended to the customers and
administers the sales ledger.

1.2 FACTORING MEANS INSTANT CASH

Factoring is a collection and finance service designed to improve your
cash flow, turning your credit sales invoices into ready cash. Through
factoring. Factors agrees to
• Factor your invoices on a continuing basis;
• Pre-pay up to 80% of the value of the invoices immediately; and
• Perform the accounting function of sales ledger maintenance and
the collection function of realizing invoices factored.

1.3 HOW FACTORS WORK?

• The client will invoice their customer in the usual way-only
adding a notification that the invoice is assigned to and must be paid to
the factors.
• The client will submit copies of invoices to factors, accompanied
by the receipt delivery challan or any other valid proof of dispatch.
• The Factor will provide pre-payment up to 80% of the invoice
value.
• Follows up with the customer for realization of payment due.
• Balance payment made immediately on realization.
• To keep clients informed of the factored invoices, the factors will
send them monthly statement of account.

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 1.4 COST OF FACTORING
Finance Charge
Finance charge is computed on the pre-payment outstanding in your
account at monthly intervals. Factoring can be cheap source of funds, provided
you organize your drawls from the factor.

Service Charge/Handling Charge

Service/Handling charge is a nominal charge levied to cover the cost of
services viz. collection, sales ledger management and periodical MIS reports. It
ranges from 0.1% to 0.2% on the total value of invoices factored/ collected by
us. The tax payable on Service/Handling charges is also recovered from clients.

1.5 MODUS OPERANDI

The factor provides finance to his client up to a certain percentage of the
unpaid invoices which represent the sale of goods or services to approved
customers. The modus operandi of the factoring scheme is as follows:

 There should be a factoring arrangement between the client and the factor,
which is the financing organization.

 Whenever the client sells goods to trade customers on credit, he prepares

invoices in the usual way.

 The goods are sent to the buyers without raising a bill of exchange but
accompanied by an invoice.

 The debt due by the purchaser to the client is assigned to the factor by
advising the trade customers, to pay the amount due to the client, to the
factor.

 The client hands over the invoices to the factor under cover of a
schedule of offer along with the copies of invoices and receipted
delivery challans or copies of R/R or L/R.

 The factor makes an immediate payment up to 80% of the assigned

invoices and the balance 20% will be paid on realization of the debt.

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1.6 MECHANISM OF FACTORING

The various steps involved in the factoring process can be better

explained with the help of a diagram:

FIG. 1

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1.7 FUNCTIONS OF FACTORING
Factoring involves the following functions:
• Purchase and collection of debts.
• Sales ledger management.
• Credit investigation and under taking of credit risk.
• Provision of finance against debts.
• Rendering consultancy services.

(i) Purchase and collection of debts:

Factoring envisages the sale of trade debts to the factor by the company,
i.e., the client. The factor purchases the entire trade debts and thus he becomes
a holder for value and not an agent. Once the debts are purchased by the factor,
collection of those debts becomes his duty automatically.

(ii) Sales ledger management:

Once the factoring relationship is established, it becomes the factor's
responsibility to take care of all the functions relating to the maintenance of
sales ledger. The factor has to credit the customers account whenever payment
is received, send monthly statements to the customers and to maintain liaison
with the client and the customer to resolve all possible disputes.

(iii) Credit investigation and under taking of credit risk:

The factor has to monitor the financial position of the customer
carefully, since; he assumes the risk of default in payment by customers due to
their financial in ability to pay. Before accepting the risk, he must be fully
aware of the financial viability of the customers, his past financial performance
record, his future ability, his honesty and integrity in the business world. For
this purpose, the factor also under takes credit investigation work.

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(iv) Provision of finance:
After the finalization of the agreement and sale of goods by the client,
the factor provides 80% of the credit sales as prepayment to the client. Hence,
the client can go ahead with his business plans or production schedule without
any interruption. This payment is generally made without any recourse to the
client.

(v) Rendering consultancy services:

The factor also provides management services to the client. He informs
the client about the additional business opportunities available, the changing
business and financial profiles of the customers, the likelihood of coming
recession.

1.8 TYPES OF FACTORING

The type of factoring services varies on the basis of the nature of
transaction between the client and the factor, the nature and volume of client's
business, the nature of factor's security. The factoring services can be classified
as follows:
• Full service or Without recourse factoring
• With recourse factoring
• Maturity factoring
• Bulk factoring
• Invoice factoring
• Agency factoring
• International factoring

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(v) Invoice Factoring:
Under this type, the factor simply provides finance against invoices
without under taking any other functions. The debtors are not at all notified and
hence they are not aware of the financing arrangement. It is also called as
"Confidential invoice discounting" or Undisclosed Factoring.

(vi) Agency Factoring:

Under this type, the factor and the client share the work between
themselves as follows:
(a) The client has to look after the sales ledger administration and
collection work.
(b) The factor has to provide finance and assume the credit risk.

(vii) International Factoring

Under this type, the services of a factor in a domestic business are
simply extended to international business. Factoring is done purely on the basis
of the invoice prepared by the experts. Thus, the exporter is able to get
immediate cash to the extent of 80% of the export invoice under international
factoring.

1.9 ADVANTAGES OF FACTORING

(A)For the client's
• Clients shall have immediate access to cash. As Factor, prepay nearly
80% of the factored invoices value, the client's get money faster.
• Their Funds are blocked for a shorter period, and they can offer
competitive terms to their customers and there by improve profit.
• With the availability of cash, liquidity improves to a great extent.
• As the Factor take care of sales ledger administration, debt collection,
the client can focus on production, marketing and other areas.
• Factor provide liberal credit periods coupled with grace period.
• There is no penal interest up to the grace period.

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 • Factoring scores over 'bill discounting' due to its value added services
like collections, invoice follow up, advisory services.
• Factor provide client's with "outstanding invoices" statements. Thus
the client's are aware with their current receivables position.

(B) For the customers(buyers) :

• Buyers have no need to accept any bill.
• Through factoring they save on bank charges and expenses.
• There is not much of documentation; the customers have to give a
"Letter of Notification" to the factor.
• The process of factoring facilitates credit purchases.
• The factor furnishes periodical statement of outstanding invoices
drawn on the buyers.
• Buyer to have adequate credit period for payment.

(C) For the Bankers:

• Factoring is not a threat to banking; it is a financial service
complementary to that of the banks.
• Factoring improves liquidity of the borrowers.
• Credit sales are closely monitored by the Factor and proceeds are
routed through the clients' accounts with the bank.
• Factoring improves the quality of advances of banks.
• Ultimately it is said that factoring is a continuing legal relationship
between a financial institution (factor) and a business concern (client)
selling goods or services to other concerns book debts, either with or
without recourse to the client and in relation there to controls the credit
extended to customers and maintains the sales ledger.

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1.10 DISADVANTAGES OF FACTORING
• Factoring is generally costlier than other forms of working capital
finance.
• Though the discount charges are at par, other charges like service charges
and processing fees make the whole transaction costlier. Hence, it is
considered the option of last resort.
• Small companies who need this facility the most may not be able to take
advantage as the factors generally put prerequisite conditions in
terms of minimum turnover, current ratio, etc.
• Companies that have large number of debtors for small amounts may not
be able to enter into a factoring agreement as the screening of the
customers becomes very difficult for the factor. Similar is the case with
companies with speculative businesses.
• Since there is no law dealing with factoring specifically, the rights of the
factor as regards the debts purchased are not clear. As an assignee of a
trade debt, it owns a pure intangible claim.

1.11 RULES OF RBI

Acting upon the recommendations of the committee, the Reserve Bank
of India issued guidelines permitting commercial banks to start separate
subsidiaries for rendering factoring services.
The Banking Regulation Act. 1949 was amended in 1990. to enable
commercial banks to undertake factoring business. In July 1990, RBI proposed
the following:
• After prior permission form RBI. banks can promote subsidiaries offering
factoring services.
• A factoring company cannot engage in factoring another factoring
company.
• Banks' can't invest in a factoring company's shares more than 10% of their
paid up capital & reserves.

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RBI identified 4 Nationalized Banks to function in the 4 regions of the country:
• SBI in western region
• Canara bank in Southern region
• Allahabad bank for Eastern region
• PNB for Northern region.

Amongst the above, only the first two have ventured into factoring (through
their subsidiaries). Later, RBI relaxed the zonal wise restrictions. Some of the
prominent factoring companies functioning in India are:
• SBI Factors
• Canara bank Factors
• Foremost Factors
• ECGC
• Global Trade & Finance Ltd
• HSBC
• SIDBI

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1.12 BANKING VS FACTORING
The differences between Banking and Factoring are shown in the
following table.
Table 1.1
Banking vs. Factoring

S.No Area Factoring Banking

1. Funding Up to 80% or more Normally 50% to 60%
2. Grace Period Up to 60 days Usually nil
Not carried out
3. Collections In-built
automatically

No penalty up to grace OD interest for

4. Penalty
period irregularity

Instant credit against Payments in periodic

5. Availability
invoices intervals
Closely followed up.
Follow up to
6. Reminder sent to No such service
receivables
customers.
Here there is substitution Banks play a
7. Sundry creditors
of creditors. supplementary role.

Sales ledger
Value added administration, MIS Only financing is
8.
services support, advisory services, provided
etc

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