Unit – V: Other financial services

Factoring
• Factoring is a financial service in which the
business entity sells its bill receivables to a
third party at a discount in order to raise
funds. Factoring involves the selling of all the
accounts receivable to an outside agency.
Such an agency is called a factor.
• PARTIES INVOLVED IN FACTORING
• The parties involved in the factoring
transaction are:-
• a) Supplier or Seller (Client)
• b) Buyer or Debtor (Customer)
• c) Financial Intermediary (Factor)
 CONCEPT OF FACTORING
• The seller 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. However, the factor does
not make the payment of all invoices immediately to
the seller.
• Rather, it pays only up to 75 to 80 percent of the
invoice value after deducting the discount.
• The remaining 20 to 25 percent of the invoice value is
paid after the factor receives the payments from the
seller’s customers. It is called factor reserve.
 FUNCTIONS OF FACTOR

• The factor performs the following functions:

• MAINTENANCE OF SALES LEDGER
• A factor is responsible for maintaining the
sales ledger of the client. So the factor takes
care of all the sales transactions of the client.
• FINANCING
• The factor finances the client by purchasing all
the account receivables.
• CREDIT PROTECTION
• In the case of non-recourse factoring, the risk
of non-payment or bad debts is on the factor.
• COLLECTION OF MONEY
• The factor performs the duty of collecting
funds from the client’s debtors. This enables
the client to focus on core areas of business
instead of putting energies in the collection of
money.
 FACTORING PROCESS
• The following steps are involved in the process of
factoring:
• The seller sells the goods to the buyer and raises
the invoice on the customer.
• The seller then submits the invoice to the factor
for funding. The factor verifies the invoice.
• After verification, the factor pays 75 to 80 percent
to the client/seller.
• The factor then waits for the customer to make
the payment to him.
• On receiving the payment from the customer, the
factor pays the remaining amount to the client.
• Fees charged by factor or interest charged by a factor
may be upfront i.e. in advance or it may be in arrears.
It depends upon the type of factoring agreement.
• In case of non – recourse factoring services factor
bears the risk of bad debt so in that case factoring
commission rate would be comparatively higher.
• The rate of factoring commission, factor reserve, the
rate of interest, all of them is negotiable. These are
decided depending upon the financial situation of the
client.
 ADVANTAGES OF FACTORING

• It reduces the credit risk of the seller.

• The working capital cycle runs smoothly as the
factor immediately provides funds on the
invoice.
• Improves liquidity and cash flow in the
organization.
• It leads to improvement of cash in hand. This
helps the business to pay its creditors in a
timely manner which helps in negotiating
better discount terms.
• There is a saving for repaying the money to the
factor.
 DISADVANTAGES OF FACTORING
• Factor collecting the money on behalf of the
company can lead to stress in the company and
the client relationships.
• The cost of factoring is very high.
• Bad behavior of factor with the debtors can
hamper the goodwill of the company.
• Factors often avoid taking responsibility for
risky debtors. So the burden of managing such
debtor is difficult.
• The company needs to show all the details
about company customers and sales to factor.
 Types/forms of factoring
• Full service factoring(without recourse factoring)
• With recourse factoring
• Maturity factoring
• Bulk factoring
• Invoice factoring
• Agency factoring
• International factoring
• Limited factoring
 Legal aspects of factoring
• (1)The client gives an undertaking to sell and the factor agrees
to purchase receivables subject to terms and conditions
mentioned in the agreement.

(2) The client justifies that the receivables are valid

enforceable, undisputed and recoverable. He also undertakes
to settle disputes, damages and deduction relating to the bills
assigned to the factor.

(3) The client agrees that the bills purchased by the factor will
arise only from transactions specifically approved by the
factor or those falling within the credit limits authorized by the
factor.

(4) The client notices all the customers whose receivables

have been factored.
• (5) The client agrees to provide copies of all invoices,
credit notes, etc., relating to the factored accounts, to
the factor and the factor in turn would remit the
amount received against the factored invoices to the
client.

(6) The factor acquires the power of attorney to assign

the debts further to the client in respect of such debts.

(7) The time frame for the agreement and the mode of
termination are specified in the agreement.

(8) The legal status of a factor is that of an assignee.

The customer has the same view towards the factor as
 Methods of evaluation
• 1.Net benefit method:
Net benefit = expected benefits > expected costs

2. Effective rate of interest method.

 Factoring scenario in India.
• Factoring services in India was started by
Vaghul Working group.
• It was recommended that banks and private
non-banking financial companies should be
encouraged to provide factoring services to
help the industrialists.
• In January 1988, RBI under the chairmanship
of Mr. C.S. Kalyanasundaram, former
Managing Director of SBI, examined the
feasibility of starting factoring services.
• Factoring services were started from July
1990.
RBI is of the view that:
 Banks should not directly undertake the
business of factoring.
 Banks may set up separate subsidiaries or
invest in factoring companies jointly with
other banks.
 Banks can invest in the shares of factoring
companies not exceeding 10% .
 Bill discounting
• Bill discounting is an arrangement whereby
the seller recovers an amount of sales bill
from the financial intermediaries before it is
due. Such intermediaries charge a fee for the
service. From the other side, it is a business
vertical for all types of financial intermediaries
such as banks, financial institutions, NBFCs,
etc.
• The process of bill discounting is simple and
logical.
• The seller sells the goods on credit and raises
invoice on the buyer.
• The buyer accepts the invoice. By accepting,
the buyer acknowledges paying on the due
date.
• Seller approaches the financing
company/Bank to discount it.
• The financing company/Bank assures itself of
the legitimacy of the bill and creditworthiness
of the buyer.
• The financing company avails the fund to the seller
after deducting appropriate margin, discount and
fee as per the norms.
• The seller gets the funds and uses it for further
business.
• On the due date of payment, the financial
intermediary or the seller collects the money from
the buyer. ‘Who will collect the money’ depends on
the agreement between the seller and financing
company.
 Characteristics
• Examination of bill
• Credit customer account
• Control over accounts
• Sending bills for collection
• Remits the payment to the banker
• Dishonour
Parties involved in Bill discounting
• Drawer(seller)
• Bank/financial intermediary
• Acceptor(purchaser)
 Legal aspects
• The RBI has setup many committees for the
development of commercial bills market and
also for analyzing the system of bank
financing.Some of the important committees
include:
• Dahejia Committee,1969
• Tandon Committee,1974
• Chore Committee,1980
• Vaghul Committee,1985
 Credit rating
• A credit rating is a quantified assessment of
the creditworthiness of a borrower in general
terms or with respect to a particular debt or
financial obligation. A credit rating can be
assigned to any entity that seeks to borrow
money—an individual, corporation, state or
provincial authority, or sovereign government.
• A credit rating not only determines whether or
not a borrower will be approved for a loan or
debt issue but also determines the interest
rate at which the loan will need to be repaid.
• Individual credit is rated on a numeric scale based
on the FICO calculation, bonds issued by businesses
and governments are rated by credit agencies on a
letter-based system.
• FICO(Fair, Isaac and Company)Scores
are calculated using many different pieces of credit
data in your credit report. This data is grouped into
five categories: payment history (35%), amounts
owed (30%), length of credit history (15%), new
credit (10%) and credit mix (10%).
Process
Credit rating agencies in India
 Financial dimensions of crediting rating
methodology
• The credit rating agencies are regulated by
SEBI. The main elements of its regulatory
framework are
1. Registration
2. General obligations
3. Restrictions on the ratings of securities
4. Procedure for inspection and investigation
5. Action in case of default
Types of ratings and symbols.