Factoring

Credit management is a specialized activity, is involves lot of

time and effort of a company. Collection of receivables possesses a
problem, particularly for a small scale enterprise. Banks have the
policy of financing receivables. However, this support is available
for limited period and the seller of goods and services has to bear
the risk of default by debtors. A company can assign its credit
management and collection to specialist organization, call
factoring organizations. Factoring is a popular mechanism of
managing; financing and collecting receivables in developed
countries like U. S. and U. K. and has extended to a number of
other countries in the recent past, including India.

Nature of Factoring

Factoring is a unique financial innovation. It is both a

financial as well as a management support to a client. It is a
method of converting a non – productive, inactive asset (i.e.
receivables) into a productive asset (viz. cash) by selling
receivables to a company that specializes in their collection and
administration. For a number of companies, cash may become
scarce resources if it takes a long time to receive payments for
goods and services supplied by them. Such a current assets in the
balance sheet is, in fact, illiquid and serves no business purpose; it
is much better to sell that assets for cash which can be immediately
employed in the business. A factor makes the conversion of
receivables into cash possible.

One can define factoring as “a business involving a

continuing legal relationship between a financial institution (a
factor) and a business concern (the client) selling goods or
providing services to trade customers (the customer) whereby the
factor purchases the client’s accounts receivable and in relation
thereto, control the credit, extended to customers and administers
the sales ledger”.

Factoring may also be defined as “a contract between the

suppliers of the goods/services and the factor under which (a) the
suppliers and its customers (debtors) other than those for the sell of
goods bought primarily for there personal, family or household use
(b) the factor is to perform at least two of then following functions,
(1) Finance for the supplier, including loans and advance
payments; (2) maintenance of accounts (ledgering relating to the
receivables); (3) collection of accounts (ledgering relating to the
receivables and (4) protection against default in payment by
debtors; (c) notice of assignment of the receivables is to be given
to debtors”. the agreement between the supplier and the factor
specifies the factoring procedure. Usually, the firm sends the
customers order to the factor for evaluating the customer’s
creditworthiness and approval. Once the factor is satisfied about
the customers credit worthiness and agrees to buy receivables, the
firm dispatches goods to the customers. The customer will be
informed that his account has been sold to the factor, and he is
instructed to make payment directly to the factor. To perform his
functions of credit evaluation and collection for a large number of
clients a factor may a credit department with specialized staff.
Once the factor has purchased firm receivables and if he agrees to
own them, he will have to provide protection against any bad-debts
losses to the firm.
Factoring Services:

While purchase of receivable is fundamental to the functioning of

factoring, the factor provides the following three basic services to
clients.

 Sales ledger administration and credit management.

 Credit Collection and protection against default and bad –
debt losses.
  Financial accommodation against the assigned book debt
(receivables).

Credit Administration:
A factor provides full credit administration services to his
clients. He helps and advises them from the stage of deciding
credit extension to customer to the final stage of book debt
collection. The factor maintains an account for all customers of all
items owing to them, so that collections could be made on due date
or before. He helps clients to decode whether or not and how much
credit to extend to customer. He provides clients with information
about market trends, competition and customers and helps them to
determine and credit worthiness of customers. He makes a
systematic analysis of the information regarding credit for its
proper monitoring and management. He prepaires a number of
report regarding credit and collection, and supplies them to clients
for their perusal and action.

Credit collection and protection:

When individual book debt becomes due from the customer,
the factor undertakes all collection activity that is necessary. He
also provides full or partial protection against bad debts. Because
of his dealings with a variety of customers and default with
different paying habits, he is in a better position to develop
appropriate strategy to guard against possible default.

Financial assistance:
Often factors provide financial assistance to the clients by
extending advance cash against book debt. Customers of “clients”
become debtors of a factor and have to pay to him directly in order
to settle their obligations. Factoring thus involves an outright
purchase of debts, allowing full credit protection against any bad
debts and providing financial accommodation against the forma
book debts.
 In view of the services provided by a factor, factoring
involves the purchase of a client’s book debt with the purpose of
facilitating credit administration, collection and protection. It is
also a means of short term financing. It provides protection against
the default in payment for book debts. For these services, the
factor, however, charges a fee from the client. Thus, factoring has a
cost.

Other Services:
In developed countries like USA, factors provide many other
services. They include i) providing information on prospective
buyers ii) providing financial counseling; iii) assisting the client in
managing its liquidity and preventing sickness; iv) financing
acquisition of inventories; v) providing facilities for opening letter
of credit by the clients etc.
Merits and Demerits of Factoring
Advantages of Factoring:

1. There are no chances of bad debts, especially in the case of

without recourse arrangements.
2. Continuous factoring may eliminate the need for the credit
and collection department, in other words, the seller is free
from the burden of credit administration & collection
problems of credit sales.
3. The liquidity position of the sellers improves, as he can
obtain about 80% of the amount prepaid by the factor.

Limitations of Factoring:

1. The cost of factoring (interest on advances, and the

commission) tends to higher than the other forms of short
term borrowings.
2. Factoring of debts may be seen as the sign of financial
weakness to collect dues.
3. The factor does ensure the responsibility of factoring of all
the credit account, as the factor is selective in factoring
arrangement.
Aspect responsible for the need of factoring:

Credit Policy of the company:

Credit period means the period allotted to the debtors of the

company to make the due payment. The period allotted to the
debtors depends upon how the credit policy of the company is. The
term credit policy refers to the combination of three decision
variables.
 Credit standards: these are the criteria to decide the types of
customers to whom goods could be sold on credit. If a firm
has more slow-paying customers its investments in account
receivables will increase. The firm will also be exposed to
higher risk of default.

 Credit terms: it specifies duration of credit and terms of

payments by customers. Investment in account receivables
will be high if the customers are allowed extended time
period for making payments.

 Collection efforts: it determines the actual collection period.

The lower the collection period, the lower the investment in
accounts receivables and vice versa.

Goals of Credit Policy:

A firm may follow a lenient or a stringent credit policy. The

firm following a lenient credit policy tends to sell on credit to
customers on very liberal terms and standards; credit are granted
for longer periods even to those customers whose credit worthiness
is not fully known or whose financial position is doubtful. In
contrast, a firm following a stringent credit policy sells on credit on
a highly selective basis only to those customers who have proven
credit worthiness and who are financially strong.

 Marketing Tool:
Firms use credit policy as a marketing tool for expanding sales. In
a declining market, it may be used to maintain the market share.
Credit policy helps to retain old customers and create new
customers by weaning them away from the competitors. In a
growing market, it is used to increase the firm’s market share.
Under a highly competitive situation or recessionary economic
conditions, a firm may loosen its credit policy to maintain sales or
to minimize erosion of sales.
In practice, companies may grant credit for several other reasons
such as the company position, buyer’s status and requirement &
dealer’s relationship, transit delays, industrial practice etc.

Why do companies in India grant credit?

Companies in practice feel the necessity of granting credit for

several reasons:

 Competition:
Generally, higher the degree of competition, the more the credit
granted by a firm. However, there are exceptions such as firms in
the electronic industry in India.

 Company’s bargaining power:

If a company has a higher bargaining power vis-à-vis its buyer’s, it
may grant no or less credit. The company may have a strong
bargaining power if it has a strong product, monopoly power,
brand image, large size or strong financial position.

 Buyer’s requirements:
In a number of business sectors buyer’s/ dealers are not able to
operat e without extended credit. This is particular so in the case of
industrial products.

 Buyer’s status:
Large buyers demand easy credit terms because of bulk purchases
& higher bargaining power. Some companies follow a policy of not
giving much credit to sall retailers since it is quite difficult to
collect dues from them.

 Relationship with dealer:

Companies sometimes extend credit to dealers to build long tern
relationships with them or to reward them for their loyalty.

 Marketing tool:
Credit is used as a marketing tool, particularly when a new product
is launched or when a company wants to push its weak products.

 Industry practice:
Small companies have been found guided by industry practice or
norm more than the large company. Sometimes companies
continue giving credit because of past practice rather than industry
practice.
  Transit delays:
This is a forced reason for extended credit in the case of a number
of companies in India. Most companies have evolved systems to
minimize the impact of such delays. Some of them take the help of
banks to control cash flows in such situations.
Process of Factoring:
The factoring process with Factoring Associates is fast and easier
than you might have thought:
Step One
Fill out the proper documentation (which we will provide you).

Step Two
Once the documentation process is complete, Factoring Associates
provides you with cash for your receivables.

Step Three
Once we have verified your invoice, we send you an immediate
advance. You may choose to receive anywhere between 50 and
85% of the total invoice, and the cost or discount is proportionate
to this percentage. Most factoring advances are between 70-80%
and are either wired directly to your bank account, sent through the
mail or via Federal Express. This step is generally completed
within 24 hours.

Step Four
Once your customer's check clears, or according to a prearranged
schedule, we send you the remaining funds (known as the
Reserve). At this juncture, we generally take our fee off the top.
Our fee ranges from 2-4% per 15-30 days. In this case, you will
have received 96-98% of your money, and the transaction is
considered complete.

Step Five
With each invoice you factor, you will receive a complete
statement of account, which displays of your invoices, fees and
other pertinent information. You will also receive copies of
customer checks for your records on the date of receipt.
Types of Factoring:

 Full service non-recourse:

 Full service recourse factoring:
 Bulk/Agency factoring:
 Non-notification Factoring:

 Full service non recourse:

Under this method, book debts are purchased by the factor,

assuming 100% credit risk. The full amounts of invoices have to be
paid to clients in the event of debt becoming bad. He also advances
cash upto 80-90% of the book debt immediately top the client.
Customers are required to make payment directly to the factor. The
factor maintains the sales ledger and accounts and prepares age-
wise reports of outstanding book debts.

Non recourse factoring is most suited to the following situations

where:
o Amounts involved per customer are relatively substantial and
financial failure can jeopardize clients business severely;
 o There are a large number of customers of whom the client
cannot have personal knowledge; and
o The clients prefer to obtain 100% cover under factoring
rather than take insurance policy which provides only 70-
80% cover.

 Full service reverse factoring:

In this method of factoring, the client is not protected against the

risk of bad debts. He has no indemnity against unsettled or
uncollected debts. If the factor has advance funds against book
debts on which a customer subsequently defaults, the client will
have to refunds the money.
Most countries practice recourse factoring since it is not easy
to obtain credit information, and the cost of bad debt protection is
very high. This type of factoring is often used as a method of short
term financing, rather than pure credit management and protection
service. It is less risky from the factors point of view, and thus, it is
less expensive to the client than non recourse factoring. This type
of factoring is also preferred when large spread of customers with
relativity low amount per customer is involved, or the client is
selling to high risk customer.

o Advance factoring and maturity factoring:

The non recourse and recourse factoring can be further classified

into:

Advanced Factoring
Maturity factoring

Under the advanced factoring, the factor advances cash

against book debts due to the client immediately. Maturity
factoring implies that payment will be made to the client on
maturity. In the case of non recourse maturity factoring payment is
on maturity or when the book debts are collected, or on the
insolvency of the customer. In the case of recourse maturity
factoring, the factors pays to the client when the book debts have
been collected the client with sound financial condition & liquidity
may prefer maturity factoring

o Bulk agency Factoring:

This type of factoring is basically used as a method of

financing book debts. Under this the client continues to administer
credit & operate sales ledger. The factor finances the book debt
against bulk either on recourse or without recourse. This sort of
factoring became popular with the development of mini-
computers. Mini computers where marketing and credit
management was not a problem but the firms needed temporary
financial accommodation. Those companies which have good
systems of credit administration, but need finances, prefer this
form of factoring.

o Non- notification factoring:

In this type of factoring, customers are not informed about

the factoring agreement. It involves the factor keeping the accounts
ledger in the name of a sales company to which the client sells his
book debts. It is through this company that the factor deals with
client’s customers. The factor performs all his usual functions
without a disclosure to the customers that he owns the book debts.
This type of factoring in the UK to financially strong companies.
Illustration:
A small firm has a total credit sales of Rs. 80, 00,000/- & its
average collection period is 80 days. The past experience
indicates that bad debts loses are around 1% of credit sales. The
firm spends about Rs. 1, 20,000/- p.a on administering its credit
sales. This cost includes salaries of one officer and two clerks
who handle credit checking, collection etc., telephone and telex
charges. These are avoidable cost. A Factor is prepared to buy
the firms receivables. He will charge 2% commission. He’ll pay
advance against receivables to the firm at an interest rate of 18%
after withholding 10% as reserves. What should the firm do?

Solution:
Let us first calculate the average level of receivables.
The collection period is 80 days and the credit sales are Rs. 80,
00,000/-;
Therefore, the average level of receivables is, (assuming 360
days in a year)
Average level of Receivables = credit sales / days in year *
debtors velocity

= 80, 00,000 / 360 * 80

= 17, 77,778
The advance which the factor will pay will be the average level
of receivables less factoring commission, reserves and interest
on advance. The factoring commission is 2% of average
receivables and reserves is 10%.

Factoring commission and reserves = 0.2 + 0.10 * 17, 77,778

= 2, 13,334.
Thus, the amount available for advance = 17, 77,778 – 2,
13,334 = 15, 64,444

However, the factor will also deduct 18% interest before paying
advance for 80 days, therefore, the amount for advance to be
paid by the factor =
Amount for advance = 15, 64,444 – (0.18 * 15, 64,444 * 80 /
360)
= 15, 64,444 – 62,578 = 15, 01,866

What is the annual cost of factoring to the firm? The annual

cost includes the following:
Factoring commission = 35,556 * 360 / 80 = 1, 60,002
Interest Charges = 62, 578 * 360 / 80 = 2, 81,601
4, 41,603
The firm saves the following costs:
Cost of credit administering = 1, 20,000
Cost of Bad – debt losses (0.01 * 80, 00,000) = 80,000
2, 00,000
The net cost of factoring to the firm is:
Net cost of factoring = 4, 41, 603 – 2, 00,000 = 2, 41,603
Effective rate of interest of firm is:
Effective rate of annual cost = 2, 41,603 / 15, 01,866 = 16%