Factoring & Forfeiting

Learning Objectives:
Introduction to Factoring Meaning of factoring Functions of factor Types of factoring Meaning and concept behind Forfaiting

Introduction to Factoring:
Buyers of goods and services often delay the payment for the same. This results in working capital problems for the supplier of goods and services. Even though banks and FIs provide WC for the suppliers, there is often more funds required for uninterrupted production. Factoring is a financial service whereby receivables are purchased by the factor. Factoring is a package of services providing integrated receivables management. It is synonymously used with accounts receivable financing.

Meaning of Factoring:
The word factor is derived from Latin word which means to get things done. A factor is an agent who does things for his client for a consideration called commission. Here a firm converts its receivables into cash by selling them to a factoring agent or institution at a discount. The factor assumes the risk of collection and the loss on account of bad debt falls on the factor. According to a financial institution, factoring means an arrangement between a person called as factor and his clients that includes at least two of the following services to be provided by the factor: a) finance b) maintenance of accounts c) collection of debts d) protection against credit risk. Thus factoring is a package of services providing integrated receivables management.

Mode of Operation:
There will be a factoring arrangement between the client and the factor. Whenever the client sells goods and services to buyers on credit, he prepares invoice in the usual way. The goods are then sent to buyers accompanied by invoice. The debt due by the purchaser to the client is assigned to the factor by instructing the purchaser to pay the amount due to the client to the factor. The seller hands over the invoice, delivery challan, etc to the factor.

 The factor then makes a payment of up to 80% of the assigned invoice to the seller and the
remaining 20% will be paid after the realization of the balance after deducting the fees.

Characteristics of Factoring:
By nature, factoring is a specialized activity where a firm converts its receivables into cash by selling them to factoring organization. The factor assumes the risk of collecting receivables with or without recourse to the client. Factoring of receivables helps the clients to manage its operations without maintaining a credit department and the debtors of the firm become the debtors of factor. Factor is mainly responsible for fulfilling the terms of the contract between the parties. Factoring firms are professionally competent skillful people who know to handle credit sales realization in different trades. Factors help in reducing the dependence on bank finance towards working capital which helps the firms to a greater extent by relieving them of finding financial alternative . Factoring might or might not be recoursed.

The process
The main function of factor is the realisation of credit sales. Once the sales transaction is completed between the firm and the buyer, the factor starts realizing the sale proceeds. The seller enters into an agreement with a factor whereby the factor provides the facility of debt collection. The sellers bank might also be in the factoring business. The seller hands over the duly signed invoice by the buyer to the factor. 80% of the invoice value is given as advance by the factor and the remaining 20% is paid against the realization of the full amount. The factor collects the service charges and the discount charge which will be comparable to bank interest rate from the seller. The maximum debt period permitted under factoring is 150 days inclusive of a maximum grace period of 60 days.

Parties involved in factoring;

There are three important parties involved in the entire process of factoring: The buyer The seller The factor

The Buyer
A buyer buys the goods and services in accordance with the negotiated terms from the business entity or firm.

He then receives the delivery of goods with the invoice and an instruction to settle the amount to the factor. If for some reasons he cannot honour the obligation in time, he has to get the extension period from the factor. In case he does not honor the obligation, the factor can take legal actions against him.

The Seller
The seller enters into an MoU with the buyer, sells the goods to the buyer. Eventually he also chooses the factor. He delivers the goods to the buyer, and thereby sends the invoice, MoU, delivery challan and the instruction to make the payment to the factor. The seller receives advance payments from the factor for selling the receivables to the buyer. This ranges from 80% to 90% of the total receivables and the remaining upon realisation of the balance.

The Factor
The relationship between a factor and a buyer depends on personal grounds and their interpersonal relationships. The firm (seller) sends the business name, address and the amount he wants to factor for a particular buyer. The firm and the factor enter an agreement for availing the factoring service. The factor after reviewing the invoice & other documents makes payment to the seller. The factor receives payments from the buyer on due dates and gives the remaining amount due to the seller after deducting his service charges.

The essential documents;

Invoice, bills or other documents by the seller with a mention of factoring services. A written statement by the seller to ensure that the bills are free from any encumbrances. Deed of assignment to enable the factor to recover the money from the seller if there is any default. A letter of confirmation stating that all the conditions of the sell-buy contract between the buyer and the seller have been complied with and the transaction is complete by the seller.

Functions of factor;
Assumption of credit risk Maintenance of sales ledger Collection of accounts receivables. Finance of trade debt Provision of advisory services Credit analysis of the customer

1. Assumption of credit risk:

A factor undertakes the risk if factoring is done without recourse. When it buys the accounts receivables, the risk of default by the customer falls on it and relieves the client from the work of collection of AR.

2. Maintenance of sales ledger:

The factor also provides the service of maintaining the sales ledger of the client. The factor prepares periodic reports regarding the current status of his receivables, receipts of payments from the customers and other related information. Customer wise record of payments over a period is also maintained to identify the defaulting accounts.

3. Collection of Accounts Receivables:

When payment is due from the customer, the factor undertakes the responsibility of collecting the money. The factor being a professional in collecting debts, has trained manpower and well-equipped infrastructure facilities for collection of debt. Entrusting the collection work to factor saves manpower, time and effort for the client and thereby he can concentrate his efforts on more productive areas.

4. Financing trade debts:

Factoring provides short-term finance to the clients. The factor purchases the book debt and gives full credit protection against any bad debts in case the debt is factored without recourse. Extending cash in advance against the book debts provides financial assistance to the seller.

5. Providing advisory services:

A factor provides following financial consultancy services to the client. Provides information regarding market trends of the clients products, marketing strategies and competition and helps the client to assess the credit worthiness of the customer. Makes systematic analysis to monitor and manage the credit recovery. Audits the procedures for invoicing, delivery and dealings with sales return.

6. Credit analysis of the customer:

Factors with their vast source of information advises the client on the credit worthiness of potential customers and help them have a better credit control. Factors prepare periodic customerwise outstanding and aging schedules and send them to the clients. With these reports the clients can assess the credit worthiness of the customers.

Benefits of factoring
1. Immediate increase in cash flow: with factoring, invoices are immediately purchased &
advances are paid up to 90% of the invoice amount. Thus invoice provides instant finance against invoice. Less cost: practically the cost is less as compared to the amount lost on account of waiting for 60, 90 days to receive payment on services or products. No penal rate is charged up to the grace period.

2. Professional Collection: a factor can handle and collect collections professionally. 3. Invoice processing: a factor handles much of the work associated with processing invoices,
depositing cheques, etc., again, this can greatly reduce the current overhead cost associated with these tasks.

4. Offer credit terms to customers: availing the services of a factor helps the company offer
credit terms to the customers without impairing the cash flow.

5. Source of finance: factoring is a source of finance and it accelerates the turnover of receivables
and improves the operating cycle and this enables the seller to meet the financial commitments without much difficulty.

6. Credit screening: factors provide credit information about new customers which enables the
seller to make better credit decisions.

7. Invoices are paid faster: if the buyer defaults the payment to the factor, the same is reported
by the factor to credit rating agencies which ultimately hampers their credit ratings. Whereas the same will not be reported by the seller if factor is not involved.

8. Factoring helps to build credit: factoring provides adequate cash flow and this enables the
company to pay its bills promptly and starts establishing or improving its credit raising capacity.

Cost of factoring:
The finance charge for the purchase of receivables is collected and the finance charge is usually 2 5 % above the market interest rate. Service charge is applicable for collection, follow-up, administration etc., and the charges are usually varying between 0.1% to 2% of the invoice value. A penal charge is levied for delayed payment. A penal charge of 1% for first 30days and 2% for delay beyond 30 days.

Types of factoring:
With recourse and non-recourse Advance and maturity factoring Undisclosed and disclosed factoring Domestic and international factoring Bulk or agency factoring Limited factoring and full factoring

Recourse factoring:
In case of recourse factoring, default risk is not borne by the factor. Here a factor provides the advance but not the credit cover. When there is a loss, the client has to make it up. If there is a default, the sales ledger maintenance and debt collection charges plus the interest on the amount for the period are collected by a factor from a client.

Non-recourse factoring:
In this case the credit risk is borne by a factor. The loss due to irrecoverable debt has to be borne by a factor and this is the reason why a high commission charge is collected by a factor. He plays a vital role along with the seller to grant credit facilities to the buyer.

Advance factoring:
Here a factor provides advance against factored receivable at an agreed interest rate. The advanced amount ranges between 75% to 90% and the seller is supposed to pay an interest for the factored amount & the balance is after the realisation of the balance amount. This might be with or without the recourse.

Maturity factoring:
Under this scheme, no financial assistance will be made available to the client and the client gets the entire amount from the factors only at the time of maturity. The factor maintains the clients sales ledger and collects the debts on time and pays the same to the client by deducting the commission thereon.

Undisclosed & disclosed factoring:

Under undisclosed factoring, the factoring arrangement between the seller and the factor is not known to the buyer. He keeps making the payment to the seller and he in turn keeps making the payment to the factor irrespective of whether the buyer makes the payment or not. Whereas in the case of disclosed factoring, the buyer knows about the factoring arrangement and he is requested by the seller to make the payments to the factor. Again both might be with or without recourse.

Domestic & International factoring:

Domestic factoring is carried out within a single country. All the parties involved, the factor, buyer and seller are all in the same country.

International factoring/Export factoring/2 factor system of factoring:

Factoring for export companies that sell goods and services to customers outside India is called export factoring. Parties involved: Exporter; Export factor; Importer; Import factor. Since there are two factor involved it is also called as 2 factor system of factoring. The agreements are made b/w the factoring company in the sellers country, exporter and import factor. Export factor purchases the sellers invoices and he enters into an agreement with an

import factor in buyers country who handles credit risk and collects the due amount from the importer.