Financial services

Factoring is a type of finance in which a business would sell its accounts receivable (invoices) to a
third party to meet its short-term liquidity needs. Under the transaction between both parties, the
factor would pay the amount due on the invoices minus its commission or fees.

Description: In order to meet short-term liquidity needs, a business has to sometimes resort to
factoring. It is slightly different from invoice financing. There are four main types of factoring -
maturity factoring, finance factoring, discount factoring, and undisclosed factoring.

The terms, as well as the nature of factoring, could differ from financial institution. The advance
rate could vary from 80 per cent to about 90-95 per cent of the total invoice amount. Once the
factor collects payments from the creditors, it pays back the rest of the money after deducting its
fee or commission.

The only benefit of factoring is that a company doesn't have to wait for two or three months and can
address its liquidity needs by approaching a financial institution.

Let's understand factoring with the help of an example. You own a business and you have accounts
receivable pending with you which will be due after three months. But in the meantime you need
access to cash to address immediate liquidity needs.

To gain access to cash, you approach a factor or a financial institution who has agreed to purchase
your invoice worth Rs 10,00,000 from ABC Ltd. The factor may choose to discount the invoice at 4
per cent and will keep RS 40,000 as part of his/her commission. The balance amount is Rs 9,60,000.

Now, the factor might not advance the entire amount of Rs 9,60,000. It would only give around 75
per cent of that which is Rs 7,20,000 in the first tranche and the rest (Rs 2,40,000) when the
financial institution receives balance payment from the customer.

Factoring, receivables factoring or debtor financing, is when a company buys a debt or invoice
from another company. Factoring is also seen as a form of invoice discounting in many markets
and is very similar but just within a different context. In this purchase, accounts receivable are
discounted in order to allow the buyer to make a profit upon the settlement of the debt. Essentially
factoring transfers the ownership of accounts to another party that then chases up the debt.
Factoring therefore relieves the first party of a debt for less than the total amount providing them
with working capital to continue trading, while the buyer, or factor, chases up the debt for the full
amount and profits when it is paid. The factor is required to pay additional fees, typically a small
percentage, once the debt has been settled. The factor may also offer a discount to the indebted
party.

Factoring is a very common method used by exporters to help accelerate their cash flow. The
process enables the exporter to draw up to 80% of the sales invoice’s value at the point of delivery
of the goods and when the sales invoice is raised.

A factor is an intermediary agent that provides cash or financing to companies by purchasing their
accounts receivables. A factor is essentially a funding source that agrees to pay the company the
value of an invoice less a discount for commission and fees. Factoring can help companies improve
their short-term cash needs by selling their receivables in return for an injection of cash from the
factoring company. The practice is also known as factoring, factoring finance, and accounts
receivable financing.

A factor is essentially a funding source that agrees to pay a company the value of an invoice less a
discount for commission and fees.

The terms and conditions set by a factor may vary depending on its internal practices.

The factor is more concerned with the creditworthiness of the invoiced party than the company
from which it has purchased the receivable.

Understanding a Factor

Factoring allows a business to obtain immediate capital or money based on the future income
attributed to a particular amount due on an account receivable or a business invoice. Accounts
receivables represent money owed to the company from its customers for sales made on credit. For
accounting purposes, receivables are recorded on the balance sheet as current assets since the
money is usually collected in less than one year.

Sometimes companies can experience cash flow shortfalls when their short-term debts or bills
exceed the revenue being generated from sales. If a company has a significant portion of its sales
done via accounts receivables, the money collected from the receivables might not be paid in time
for the company to meet its short-term payables. As a result, companies can sell their receivables to
a financial provider (called a factor) and receive cash.

There are three parties directly involved in a transaction involving a factor: the company selling its
accounts receivables; the factor that purchases the receivables; and the company's customer, who
must now pay the receivable amount to the factor instead of paying the company that was
originally owed the money.

Requirements for a Factor

Although the terms and conditions set by a factor can vary depending on its internal practices, the
funds are often released to the seller of the receivables within 24 hours. In return for paying the
company cash for its accounts receivables, the factor earns a fee.

Typically, a percentage of the receivable amount is kept by the factor; however, that percentage can
vary, depending on the creditworthiness of the customers paying the receivables.

If the financial company acting as the factor believes there's an increased risk of taking a loss due to
the customers not being able to pay the receivable amounts, they'll charge a higher fee to the
company selling the receivables. If there's a low risk of taking a loss from collecting the receivables,
the factoring fee charged to the company will be lower.

Essentially, the company selling the receivables is transferring the risk of default (or nonpayment)
by its customers to the factor. As a result, the factor must charge a fee to help compensate for that
risk. Also, how long the receivables have been outstanding or uncollected can impact the factoring
fee. The factoring agreement can vary between financial institutions. For example, a factor may
want the company to pay additional money in the event one of the company's customers defaults
on a receivable.

Benefits of a Factor

The company selling its receivables gets an immediate cash injection, which can help fund its
business operations or improve its working capital. Working capital is vital to companies since it
represents the difference between the short-term cash inflows (such as revenue) versus the short-
term bills or financial obligations (such as debt payments).

Selling, all or a portion, of its accounts receivables to a factor can help prevent a company that's
cash strapped from defaulting on its loan payments with a creditor, such as a bank.

Although factoring is a relatively expensive form of financing, it can help a company improve its
cash flow. Factors provide a valuable service to companies that operate in industries where it takes
a long time to convert receivables to cash—and to companies that are growing rapidly and need
cash to take advantage of new business opportunities.

The best factoring companies also benefit since the factor can purchase uncollected receivables or
assets at a discounted price in exchange for providing cash up front.

Forfaiting (note the spelling) is the purchase of an exporter's receivables – the amount that the
importer owes the exporter – at a discount by paying cash. The purchaser of the receivables,
or forfaiter, must now be paid by the importer to settle the debt. This is a common process used for
speeding up the cash flow cycle and providing risk mitigation for the exporter on 100% of the debts
value.
As the receivables are usually guaranteed by the importer's bank, the forfaiter frees
the exporter from the risk of non-payment by the importer. When a forfaiter purchases the
exporter’s receivables directly from the exporter then it is referred to as a primary purchase. The
receivables technically then become a form of debt instrument that can be sold on the secondary
market as bills of exchange or promissory notes, this is known as a secondary purchase.

Forfaiting is the provision of medium-term financial support for the import and export of capital
goods. The forfaiter is a third party to transactions that takes on certain risks from importers and
exporters in return for a margin. The forfaiter operates similarly to a central clearing counterparty
in the OTC mark

Forfaiting is originally a French word, meaning to relinquish a right. The term implies a transaction
where the forfaiter purchases claims (receivables) from the exporter in return for cash payment.

Summary

Forfaiting is the provision of medium-term financial support for the import and export of capital
goods.

Major sources of export financing are working capital financing, countertrade, factoring, and
forfaiting.

Forfaiting is a mechanism where the exporter surrenders his rights to receive payment against the
goods and services rendered to the importer, in exchange for a cash payment from the forfeiter.

Characteristics of a Forfaiting Transaction

The common characteristics of a forfaiting transaction could be:

The minimum bill size is either $250,000 or $500,000

The length of credit extended to the importer ranges from six months to seven years

It is receivable in any major convertible currency, e.g., USD, CAD, EUR, etc.

A contract for goods and services

A written letter of credit or a guarantee is made by a bank, usually in the importer’s country

Major Sources of Export Financing

1. Working Capital Financing

Banks may provide short-term loans that finance the working capital cycle from the purchase of
inventory until the eventual conversion to cash. It is a way to access debt financing through a loan
that is taken to finance a company’s everyday operations. Such a form of debt financing restricts the
deployment of capital on long-term assets, such as property, plant, and equipment (PP&E), or other
long term investments.

2. Countertrade

Countertrades are foreign trade transactions where the sale of goods to a country can be linked to
the purchase of exchange of goods from the same country. The most common types include
bartering, product buy-backs, and counter-purchase. Such a method of international trade is more
common in developing countries with limits on foreign exchange or credit facilities.

3. Factoring

Factoring is an arrangement that can help increase liquidity for transactors by offering the
conversion of receivables into ready cash. In factoring arrangements, trade receivables on ordinary
goods are sold, with financing up to 90% with or without recourse. The factoring arrangements do
not involve negotiable instruments or take place in the secondary market.

Factoring refers to a method of managing book debt, in which a business receives advances against
the account’s receivables, from a bank or financial institution. The three parties involved in
factoring are the seller, customer, and the factor.

4. Forfaiting

Forfaiting is a mechanism where the exporter surrenders his rights to receive payment against the
goods and services rendered to the importer in exchange for a cash payment from the forfaiter.
Through forfaiting, the exporter can easily convert a credit sale into a cash sale, without recourse to
him or his forfaiter.

In forfaiting arrangements, the trade receivables must involve capital goods and are financed up to
100% without recourse. The arrangements can involve dealing with negotiable instruments.

What Information Does a Forfaiter Need?

The forfaiter requires the following information to participate in the transaction:

The identity of the buyer

Buyer’s nationality

Nature of goods sold

Detail of the value

Currency of contract

Date and duration of the contract

Credit terms

Payment schedule

Interest rate

Know what evidence of debt will be used, e.g., promissory notes, bills of exchange, letter of credit,
etc.

The identity of the guarantor of payment

Documents Required by the Forfaiter from the Exporter

Copy of supply contract, or its payment’s terms

Copy of shipping documents, including airway bill, bill of lading, certificates of receipt, railway bill,
or equivalent documents

Copy of signed commercial invoice

Letter of assignment and notification to the guarantor

Letter of guarantee

Bill discounting and re-discounting:

 • Discounting: Commercial Banks usually purchase commercial papers below the face
value and then receive its face value on maturity date (say 90 days). The discount, (or) the
difference between the purchase price and the face value of the bill, is the
interest received on the investment.
• For example, if a Commercial Bank purchase a commercial paper at Rs.900 and then
receive Rs.1000 on the date of maturity (say 90 days). The discount, (or) difference
between the purchase price and the face value of the bill is Rs.100, is the interest received
on the investment.
• Rediscount: Re-discount is discounting a short-term negotiable debt instrument for a
second time. The Central Bank provides loans to the commercial banks by re-discounting
(buying back) the commercial papers held by them before their termination (say 90
days).The rate at which the RBI discounts the CPs is known as Bank rate or discount rate.
• For example, if a Commercial Bank purchase a commercial paper at Rs.900 and then
receive Rs.1000 on the date of maturity (say 90 days). The Discount, (or) difference
between the purchase price and the face value of the CP is Rs.100, is the interest received
on the investment by the bank. If the same commercial bank is in urgent need of money
after 30 days, the Central-Bank provides loan by re-discounting (buying back) same
commercial paper held by the bank for Rs.950 for a period of next 30 days, but, before date
of maturity of the CP (say 90 days). Here, the Re-discount, (or) the difference between
purchase price (Rs.950) and face value of the CP (Rs.1000) is Rs.50, is the
interest received on the investment by the Central Bank.

What Is a Rediscount?

A rediscount occurs when a short-term negotiable debt instrument is discounted for a second time.
The reason an issuer would do this is to spark demand for loans when investor interest dries up.
When liquidity in the market is low, banks can thus try to raise capital by rediscounting.

A rediscount is also a method for commercial banks to obtain financing from a central bank.

A rediscount is the lowering of the marketable value of a debt instrument for a second time,
increasing the difference between the discount price and its par value.

Rediscounting is used to spark new demand among bond investors and help companies to raise
debt capital in otherwise pessimistic markets.

Rediscount can also refer to financing provided by central banks to banks, where the central bank
will rediscount a discounted promissory note from a borrower to a bank to generate liquidity for
the bank.

Understanding Rediscounting

To entice investors, debt issuers may offer their bonds at a discount to par, meaning that investors
can purchase a bond for less than its par value and receive the full par value of the bond when it
matures. If the first debt offer does not generate much interest, the issuer may apply an additional
discount, increasing the difference between the discount price and the par value. When this occurs,
the issuer is said to rediscount the bonds.
The term “rediscount” also refers to the process by which a central bank or the Federal Reserve
(Fed) discounts a note that has already been discounted by a bank or discount house. A central
bank's discount facility is often called a discount window—named after the days when a clerk
would go to a window at the central bank to rediscount a company's securities.

Bill Discounting is short-term finance for traders wherein they can sell unpaid invoices, due on a
future date, to financial institutions in lieu of a commission. The Bank purchases the bill
(Promissory Note) before its due date and credits the bill’s value after a discount charge to the
customer’s account. The Bank will realise the bill amount on the bill’s due date directly from the
debtor. This helps the traders optimise their cash flows and business (payment) cycles without
disturbing their balance sheets. Lenders usually offer tenors of up to 180 days while offering bill
discounting facilities.

In trade, bill discounting is a method through which an entity can sell its unpaid invoices
(receivables) to a 3rd party financier—a bank or any other financial institution which provides the
facility of bill discounting. Against the unpaid bill, the financier provides short-term aid in the
working capital requirement of the entity that sold the unpaid bill and charges a specific
commission and discount rate. This process of selling and getting short-term financial assistance is
bill discounting. It is now the financier that further pursues the payment of the unpaid bill, not the
company.

Factoring and reverse factoring are the other two methods for bill discounting designed to increase
the cash in-flow in the company efficiently. They do so without disturbing the other financial
statement but accomplish the same purpose as bill discounting.

What is Consumer Credit?

Consumer credit often referred to as consumer debt is the debt taken by an individual to buy goods
and services. Consumer credit can be in the form of a credit card or any type of personal loan.

Understanding Consumer Credit

In simple words, consumer credit is the term used to define an unsecured debt that was taken to
purchase goods and services. However, debts taken for the purchase of a plot or house are not
included under consumer credit.

Consumer credits are generally offered by financial institutions or banks to help customers buy
everyday goods and services at any instant. In return, the consumers are charged interest over the
time taken to repay the debt.

Consumer credit is personal debt taken on to purchase goods and services. A credit card is one form
of consumer credit.
Although any type of personal loan could be labeled consumer credit, the term is more often used to
describe unsecured debt that is taken on to buy everyday goods and services. However, consumer
debt can also include collateralized consumer loans like mortgage and car loans.

Consumer credit is also known as consumer debt.

Installment credit is used for a specific purpose and is issued for a set period of time.

Revolving credit is an open-ended loan that may be used for any purchase.

The disadvantage of revolving credit is the cost to those who fail to pay off their entire balances
every month and continue to accrue additional interest charges.

Understanding Consumer Credit

Consumer credit is extended by banks, retailers, and others to enable consumers to purchase goods
immediately and pay off the cost over time with interest. It is broadly divided into two
classifications: installment credit and revolving credit.

Installment Credit

Installment credit is used for a specific purpose and is issued at a defined amount for a set period of
time. Payments are usually made monthly in equal installments. Installment credit is used for big-
ticket purchases such as major appliances, cars, and furniture. Installment credit usually offers
lower interest rates than revolving credit as an incentive to the consumer. The item purchased
serves as collateral in case the consumer defaults

Revolving Credit

Revolving credit, which includes credit cards, may be used for any purchase. The credit is
“revolving” in the sense that the line of credit remains open and can be used up to the maximum
limit repeatedly, as long as the borrower keeps paying a minimum monthly payment on time.

It may, in fact, never be paid off in full as the consumer pays the minimum and allows the remaining
debt to accumulate interest from month to month. Revolving credit is available at a relatively high
interest rate because it is not secured by collateral.

Advantages of Consumer Credit

Consumer credit allows consumers to get an advance on income to buy products and services. In an
emergency, such as a car breakdown, that can be a lifesaver. Because credit cards are relatively safe
to carry, America is increasingly becoming a cashless society in which people routinely rely on
credit for purchases large and small.
Revolving consumer credit is a highly lucrative industry. Banks and financial institutions,
department stores, and many other businesses offer consumer credit.

Disadvantages of Consumer Credit

The main disadvantage of using revolving consumer credit is the cost to consumers who fail to pay
off their entire balances every month and continue to accrue additional interest charges from
month to month.

Plastic money may refer to the use of plastic cards like debit/credit cards in the form of electronic
transactions keeping in mind the need of the customer while making the large transactions so that
they don’t keep actual paper money with them. Various forms of plastic money include debit cards,
credit cards, Money access cards, client cards, key cards, and Cash cards. The purpose of using these
cards is only for the ease of customers so that they can make large transactions and also for their
own safety.

History of Plastic Money

The first card was introduced in the year 1967 by Barclays in London followed by Chemical Banks
in New York in the year 1969. The major significant event was the introduction of a magnetic stripe
along with personal identification numbers.

Another significant event in the history of plastic money was the introduction of a hardware
security module in order to make secure payments by using microprocessor technology in the year
1973. After this smart cards were introduced in the late 1970s and came in demand during the mid-
1980s.

Various Types of Plastic Money

Different types of cards on the basis of use are listed below:

Debit Card: When a transaction is made from a debit card, the funds are withdrawn directly from
the user’s bank account. Debit is the most common type Of plastic money used by people. The
majority of transactions are made while online shopping and ATM cash withdrawal.

Credit Card: While using a credit card users can withdraw money or borrow according to their limit.
These cards are issued mostly by the bank but also from various non-financial institutions.

Charge Card: Users with charges are required to clear their balance shown in their statement within
the given time limit issued to them. It can be considered a short-term loan.

ATM Card: These cards are used to withdraw money from the Automated Teller Machine or ATM.
ATM cards can be separately issued or a debit card can also be used as an ATM card.
The above mentioned are the major types of cards commonly used. Apart from these, other types
are listed below:

Stored Value Card

Fleet Card

Gift Card

Digital Currency

Store Card issued by any particular company to make transactions at their places only.

The card can also be differentiated on the basis of technology some of which are listed below:

Magnetic Strip Card: Magnetic strip was introduced on cards in the late 1970s. Magnetic strips
contain the data which can be read-only through physical contact or swiping action. Magnetic stripe
cards have PINs with them which have to be provided in order to authenticate the transaction.

Smart Card: These cards contain a chip which is an integrated circuit. Smart cards also contain
magnetic stripes.

Use of Plastic Money in India

In India, the use of debit and credit cards was not much common. The majority of the transactions
made through plastic money were only through ATMs. However, the use of plastic money increased
rapidly in the 2010s with the introduction of online shopping where payments are made; most
payments are made through debit and credit cards. The use of cards is said to have increased
drastically in late 2016 after the demonetization of 1000 and 500 rupee notes. Because of this
event, there was a sudden lack of cash and people tend to rely more on electronic payments like e-
wallet for which card details are mandatory.