FACTORING
INTRODUCTION
Factoring is a financial transaction and a type of debtor finance in which a business
sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a
discount. A business will sometimes factor its receivable assets to meet its present and
immediate cash needs.
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.
It is outright purchase of credit approved recievables with the factor
assuming bad debt losses.
Factoring provides sales accounting service,use of finance and protection
against bad debts.
Factoring is a process of invoice discounting by which a capital market
agency purchases all trade debts and offers resources against them.
So a factor is,
a) A Financial Intermediary
b)That buys invoices of a manufacturer or a trader,at a discount,and
c)That takes responsibility for collection of payments.
PARTIES INVOLVED-
SUPPLIER OR SELLER (CLIENT)
BUYER OR DEBTOR(CUSTOMER)
FINANCIAL INTERMEDIARY(FACTOR)
EXAMPLE OF FACTORING
Example of Factoring In Finance
Let us assume that ABC Corp. is a growing company. ABC sells goods to XYZ Ltd. worth $16000 on
credit. The amount will be encashed within 45 days.
During this period, however, ABC Corp. runs out of working capital. Therefore, ABC approaches RS
Funding Ltd. to avail factoring in finance. RS Funding agrees to buy accounts receivables at a 10%
discount. Therefore, ABC opts for a recourse factoring.
Based on the given details, determine what will happen if XYZ Ltd. defaults on its payment.
Solution:
Given:
Unpaid Invoice = $16000
Discount Rate = 10% of $16000 = $1600
Now,
Money Financed = Unpaid Invoice – Discount Rate
Money Financed = $16000 – $1600 = $14400
Hence, RS Funding Ltd. lends $14400 to ABC Corp. On the due date, if XYZ Ltd. fails to pay the
invoice amount to RS Funding Ltd., then ABC Corp. is liable to pay an outstanding sum of $16000 to
the factor.
The mechanism of factoring has been shown in
the following figure:
TYPES OF FACTORING.
1. Full Factoring :This is also known as “Without Recourse Factoring
“. It is the most comprehensive type of facility offering all types of
services namely finance sales ledger administration, collection, debt
protection and customer information.
2. Recourse Factoring :The Factoring provides all types of facilities
except debt protection. This type of service is offered in India. As
discussed earlier, under Recourse Factoring, the client’s liability to
Factor is not discharged until the customer pays in full.
3. Maturity Factoring : It is also known as “Collection Factoring “.
Under this arrangement, except providing finance, all other basic
characteristics of Factoring are present. The payment is effected to
the client at the end of collection period or the day of collecting
accounts whichever is earlier
ADVANTAGES OF FACTORING
Benefits
Even after efficient cash flow management, business entities regularly face a cash
crunch. Thus, factoring is crucial in fulfilling an urgent need for capital.
Given below are the various advantages of factoring in finance:
• Facilitates Short-Term Financial Needs: By utilizing this provision, businesses meet
numerous operational expenses such as salary disbursement, bill settlement, payment to
creditors, inventory purchase, etc.
• Provides Liquidity: It allows companies to convert their trade receivables into cash in
an emergency.
• Non-recourse Factoring Protects Against Bad Debts: The non-recourse option
transfers the credit risk and the receivables. This way, clients insulate themselves from
bad debts.
• Boosts Working Capital: When companies run out of working capital, they can raise
additional funds quickly.
• No Collateral Required: Since the factor extends funds in exchange for the receivables,
the client firm is not required to submit any collateral.
• Easily Available: Compared to business loans, factoring is easier to avail. Business loans
require thorough background checks and credit rating checks.
Drawbacks
Factoring also has certain drawbacks that cannot be overlooked.
• Primarily, it reduces the profit margin for client firms.
• Also, the factor’s decision depends upon the debtors’ credibility.
• Some customers may not prefer factoring addition; the factor directly deals with the
debtor (customer), which may hinder the relationship between the client firm and the
debtor (customer).
• Also, desperate firms end up incurring hidden costs. It further increases the financial
burden of a struggling firm.
How does factoring work in finance? Small or medium size
organizations can acquire immediate capital by transferring the
ownership of accounts receivables. A factor is a financial
institution that purchases accounts receivables at a lower price.
Here, the factor is a third party, a middleman, who gets a
commission for services rendered.
Is factoring a short-term source of finance? Yes, factoring is
a quick way of raising funds for a business. But unlike business
loans, the scrutiny is less. Businesses acquire immediate cash
without submitting any collateral. The factor acquires custody of
the invoices (accounts receivables). But with recourse factoring,
the liability again falls on the client if the debtor defaults.
