17

FACTORING
LEARNING OUTCOMES
After going through the chapter student shall be able to understand:
 Concept, Definition and Mechanism of Factoring
 Types/Forms of Factoring
 Functions of a Factor
 Benefits of Factoring
 Factors inhibiting the growth of Factoring in India
 Forfaiting
 Forfaiting vs Export Factoring
 Regulatory Aspects of Factoring

1. INTRODUCTION TO FACTORING
This concept has not been fully developed in our country and most of their work is done by
companies themselves. All units’ particularly small or medium size units have to make
considerable efforts to realize the sale proceeds without much success creating functional
difficulties for such units.
Many units under small-scale sector have become sick only because of delay/non-realization of
their dues from large units. Introduction of factoring services will, therefore, prove very beneficial
for such units as it will free the units from hassles of collecting receivables to enable them to
concentrate on product development and marketing.

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 17.2 FINANCIAL SERVICES AND CAPITAL MARKETS

2. DEFINITION AND MECHANISM

2.1 Definition and Concept
Basically, factoring is a kind of financial service in which a business organization sells its Account
Receivables to another person, called a factor, at a discount in order to raise money.
Factoring is different from bill discounting. In bill discounting invoice are discounted at a certain
rate to get the funds, whereas the concept of factoring is broader. In the factoring process, the
Account Receivables are sold to an outside agency.
Example - The seller sold good on credit and raised the invoice. However, the seller needs
immediate money to meet its working capital requirements i.e. meeting day to day expenses of the
business. For this purpose, he sold the goods to an outside agency i.e. a factor. The factor pays
the required amount to the seller after some deducting some amount. So, the entire invoice
amount is not paid by the factor. Rather, about 70-80% of the bill amount is paid by the factor. The
remaining amount is paid after the factor receives the entire bill amount from the customers
(debtors). The factor charges some commission for providing these services.
The study group appointed by the International Institute for the Unification of Private Law
(UNIDROIT), Rome, during 1988, recommended, in general terms, the definition of factoring as
under:
“Factoring means an arrangement between a factor and his client which includes at least two of
the following services to be provided by the factor:
• Finance
• Maintenance of debt
• Collection of debts
• Protection against credit risk”.
However, the above definition applies only to factoring in relation to supply of goods and services:
(i) across national boundaries; (ii) to trade or professional debtors; (iii) when notice of assignment
has been given to the debtors. Domestic factoring is not yet a well-defined concept and it has been
left to the discretion of legal framework as well as trade usage and convention of the individual
country.
In India factoring is undertaken by different bank subsidiaries like SBI Factors and Commercial
Services Ltd. Promoted by SBI and Canara Bank Factors Ltd. promoted jointly by Canara Bank,
Andhra Bank and SIDBI.
2.2 Mechanism of Factoring
In a factoring transaction, there are three parties – the factor, the client and the customers of the
client. The client is the person who is actually availing the factoring service. The factor provides

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 FACTORING 17.3

the factoring services and the customers are the persons who purchases the goods and services
on credit.
The mechanism of the factoring process has been depicted in the following diagram.

The following steps are involved in the process of factoring as shown in the above diagram:
(i) Customer places an order with the client for purchase of goods and/or services on credit.
(ii) On the basis of agreement, the client delivers the goods and sends the invoice to
customers.
(iii) The client then assigns the invoice to the factor. This is generally called, “Call sale of book
debts by the client firm to the factor”.
(iv) The factor, then, makes prepayment up to 80 per cent of the invoice value to the client.
(v) The client pays interest on advances of amount received until the cash is collected from
customer.
(vi) The factor maintains accounts receivable of the client and sends periodical statements to
the customer to accelerate the collection.
(vii) On the due date, the factor collects the invoice amount from the customer.
(viii) After that, the factor releases the remaining amount to the client after adjusting his
commission/fees.
Aforesaid steps can be explained with the help of an example:
Suppose Customer/Client has raised an order with an invoice value of ` 500000; basis that order
business delivered the product on credit basis. After this, the business sells the invoice to factoring
company to get at least 80 per cent realized value i.e. ` 400000.

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 17.4 FINANCIAL SERVICES AND CAPITAL MARKETS

This realized value can be used for further business expansion or any product development.
The business pays an interest i.e. 5% on the advance of ` 400000 until amount realized from
client. Then factoring company collects the invoice amount from customer i.e ` 500000. After this
factoring company releases the reserve amount i.e. ` 1,00,000 less 5% interest charged.
In this Debtor financing process, factoring charges also played a vital role for providing the
services. The following factoring charges are levied:
• Finance charges – Computed on the prepayment outstanding in the client’s a/c at monthly
intervals. Finance charges are only for financing that has been availed by the client. These
charges are similar to interest levied on the cash credit facilities in a bank.
• Service fee – It is a nominal charge at monthly interval to cover the cost services namely -
collection, MIS reports, sales ledger management etc. Service fee is determined on the
basis of total gross value, no. of customers, degree of credit risk etc.

3. TYPES/FORMS OF FACTORING
Depending upon the features built into the factoring arrangement to cater to the varying needs of
trade/citizens, there can be different kinds of factoring:
(i) Recourse and Non-recourse Factoring: Under a recourse factoring arrangement, the
factor has recourse to the client (firm) if the debt purchased/receivable factored turns out to be
irrecoverable. In other words, the factor does not assume credit risks associated with the
receivables.
In case of non-recourse factoring, the factor does not have the right to recourse. The loss arising
out of irrecoverable receivables is borne by the factor, as a compensation for which he charges a
higher commission.
(ii) Advance and Maturity Factoring: In advance factoring, the factor paid a pre specified
portion, ranging between three-fourths to nine tenths, of the factored receivables in advance, the
balance being paid upon collection/on the guaranteed payment date. A drawing limit, as a pre-
payment, is made available by the factor to the client as soon as the factored debts are
approved/the invoices are accounted for. The client has to pay interest (discount) on the
advance/repayment between the date of such payment and the date of actual collection from the
customers/or the guaranteed payment date, determined on the basis of the prevailing short-term
rate, the financial standing of the client and the volume of the turnover.
In maturity factoring, the factoring agency does not provide any advance to the firm. In fact, the factor makes
payment to his client after collecting the amount from the customers at the end of the maturity period.
(iii) Full Factoring: This is the most comprehensive form of factoring combining the features of
all the factoring services specially those of non-recourse and advance factoring. It is also known
as Old Line Factoring.

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 FACTORING 17.5

(iv) Disclosed and Undisclosed Factoring: In Disclosed Factoring, the name of the factor is
disclosed in the invoice by the supplier-manufacturer of the goods asking the buyer to make
payment to the factor.
However, in Undisclosed Factoring, the name of the factor is not disclosed in the invoice although
the factor maintains the sales ledger of the supplier-manufacturer. The entire realization of the
business transaction is done in the name of the supplier company but all control remains with the
factor.
(v) Domestic and Export/Cross Border Factoring: If the three parties involved, namely,
customer (buyer), client,(seller-supplier) and factor (financial intermediary) are domiciled in the
same country then it is known as domestic factoring. There are usually four parties involved in a
cross border factoring transaction. They are:
a) Exporter (client)
b) Importer (customer)
c) Export factor
d) Import Factor
It is also known as two-factor system.

4. FUNCTIONS OF A FACTOR
The main functions of a factor could be classified into five categories:
• Maintenance/administration of sales ledger: The factor maintains the clients’ sales
ledgers. On transacting a sales deal, an invoice is sent to the customer and a copy of the
same is sent to the factor. The factor also gives periodic reports to the client.
• Collection facility: The factor undertakes to collect the receivables on behalf of the client
relieving him of the problems involved in collection, and enables him to concentrate on
other important functional areas of the business. It also enables the client to reduce the cost
of collection by way of savings in manpower, time and efforts.
• Financing Trade Debts: The unique feature of factoring is that a factor purchases the book
debts of its clients at a price and the debts are assigned in favour of factor who is usually
willing to grant advances to the extent of 80% of the assigned debts.
• Credit Control and Credit Protection: Assumptions of credit risk is one of the most
important functions of the factor. This service is provided where debts are factored without
recourse. The factor in consultation with the client fixes credit limits for approved
customers.
• Advisory Services : By virtue of their specialized knowledge and experience in finance and
credit dealings and access to extensive credit information; factors can provide the following

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information services to the clients:

(i) Customer’s perception of the client’s products, changing in marketing strategies,
emerging trends etc.
(ii) Audit of the procedures followed for invoicing, delivery and dealing with sales
returns.
(iii) Introduction to the credit department of bank/subsidiaries of banks engaged in
leasing, hire-purchase, merchant banking.

5. BENEFITS OF FACTORING
The benefits of factoring have been discussed as follows:
• Factoring provides immediate cash flow in the form of 80% of the invoice value which helps
in building the liquidity position of the client. Also, this proportion of finance is higher than
bank finance against credit sales.
• It also plays an important role in client’s working capital finance.
• The cash realized by receiving advance amount from the factor can be used to accelerate
the production cycle.
• The client need not have to spend time on sales ledger maintenance, follow up and
collection of receivables as this can be done by factoring company who buys such
receivables. This helps in saving the precious time of the client as it can concentrate on its
core activities such as production, marketing etc.
• This provides comprehensive credit control system which helps in assessing the quality of
debtors and monitoring their financial health.
The factoring process helps in reducing the average receivables collection period. As a result, the
total operating cycle time of the client is also reduced. This will ultimately leads to efficient working
capital management.

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 FACTORING 17.7

6. FACTORS INHIBITING THE GROWTH OF FACTORING

IN INDIA
The factoring industry has grown up rapidly around the world. More than one lakh businesses are
currently using factoring to settle their trade transaction. However, the factoring market in India is
minuscule.
There are various factors which inhibits the overall growth of factoring markets in India which are
described as below:
(i) Lack of credit appraisal system and authentic client data base have restricted the growth
model of factoring and its arrangements.
(ii) Higher stamp duty while assigning the invoice to the factor will increase the cost of the
client which leads to reduction in factoring arrangements.
To remove the above limitations and expand the factoring market in India, the following can be
suggested:
(i) Do away with stamp duty or at least reduce it.
(ii) Incorporate a separate company which will give a true and fair credit appraisal report and
which will cover all aspect of client’s information and their accounts.
(iii) Factoring companies should expand their network and branches especially to those
localities where small scale units are located.
(iv) Work shop and seminars should be organized by factoring companies to enhance
awareness and usefulness of the factoring process.

7. FORFAITING
Forfaiting is a form of financing of receivables pertaining to international trade. It denotes the
purchase of trade bills/promissory notes by a bank/financial institution without recourse to the
seller. The purchase is in the form of discounting the documents covering the entire risk of non-
payment in collection. All risk and collection problems are fully the responsibility of the purchaser
(forfaiter) who pays cash to the seller after discounting the bills/notes.
Difference between Forfaiting vs Export Factoring
(a) A forfaiter discounts the entire value of the note/bill. In a factoring arrangement the extent of
financing available is 75-80%.
(b) The forfaiter’s decision to provide financing depends upon the financing standing of the
availing bank. On the other hand in a factoring deal the export factor bases his credit
decision on the credit standards of the exporter.

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 17.8 FINANCIAL SERVICES AND CAPITAL MARKETS

(c) Forfaiting is a pure financial agreement while factoring includes ledger administration as
well as collection.
(d) Factoring is a short-term financial deal. Forfaiting spreads over 3-5 years.

8. SOME ILLUSTRATIONS IN FACTORING

Illustration 1
A Ltd. has annual credit sales of ` 219 lakh and its average collection period is 50 days. The past
experience indicates that bad debt losses are around 2% of credit sales. The factoring is expected
to save ` 2 lakh in administration costs and also to eliminate all bad debt losses. The factor has
agreed to advance 80% of the receivables at 15% p.a. Compute the net factoring cost if factoring
commission is 2%.
Solution
Average receivable = (` 219lakh/365) X 50 = ` 30 lakh
Factoring Commission = 2% on ` 30 lakh = ` 0.6 lakh
Amount available for advance = 80% of ` 30 lakh – Factoring commission (` 0.6 lakh) = ` 23.4
lakh.
The factor will actually remit the advance net of interest for 50 days.
The annual rate of interest is 15% and so rate of interest for 50 days = (15/365) x 50 = 2.05%
Interest for 50 days on ` 23.4 lakh = 2.05% on ` 23.4 lakh = ` 0.48 lakh
The advance remitted to client = ` 23.4 lakh – ` 0.48 lakh= ` 22.92 lakh
Factoring cost for 50 days = Factoring commission + Interest
= ` 0.6 lakh + ` 0.48 lakh = ` 1.08 lakh
Factoring cost for year = (` 1.08 lakh) x (365/50) = ` 7.884 lakh
Net Factoring Cost
Particulars ` lakh
Factoring cost per year 7.884
Less: Costs saved per year
Bad Debt = 2% on ` 219 lakh 4.38
Administration cost saved 2.00 6.380
Net Factoring cost per year 1.504
Advance 22.920
Net Factoring cost per year (%) = (1.504/22.92) X 100 6.56%

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Illustration 2
A Ltd. has a total sales of ` 3.2 crores and its average collection period is 90 days. The past
experience indicates that bad-debt losses are 1.5% on Sales. The expenditure incurred by the
firm in administering its receivable collection efforts are ` 5,00,000. A factor is prepared to buy the
firm’s receivables by charging 2% Commission. The factor will pay advance on receivables to the
firm at an interest rate of 18% p.a. after withholding 10% as reserve.
Calculate the effective cost of factoring to the Firm.
Solution
`
Average level of Receivables = 3,20,00,000 × 90/360 80,00,000
Factoring commission = 80,00,000 × 2/100 1,60,000
Factoring reserve = 80,00,000 × 10/100 8,00,000
Amount available for advance =` 80,00,000 – (1,60,000 + 8,00,000) 70,40,000
Factor will deduct his interest @ 18%:-
` 70,40,000 × 18 × 90
Interest = = ` 3,16,800
100 × 360

∴ Advance to be paid = ` 70,40,000 − ` 3,16,800 = ` 67,23,200

Annual Cost of Factoring to the Firm: `
Factoring commission (` 1,60,000 × 360/90) 6,40,000
Interest charges (` 3,16,800 × 360/90) 12,67,200
Total 19,07,200

Firm’s Savings on taking Factoring Service: `

Cost of credit administration saved 5,00,000
Cost of Bad Debts (` 3,20,00,000 × 1.5/100) avoided 4,80,000
Total 9,80,000
Net cost to the Firm (` 19,07,200 – ` 9,80,000) 9,27,200
` 9,27,200 × 100
Effective rate of interest to the firm =
67,23,200 13.79%

Note: The number of days in a year has been assumed to be 360 days.

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 17.10 FINANCIAL SERVICES AND CAPITAL MARKETS

9. REGULATORY ASPECTS OF FACTORING

In India, Regulatory Aspects of Factoring can be referred from Factoring Regulation Act, 2011 and
Non-Banking Financial Company - Factors (Reserve Bank) Directions, 2012.
9.1 Provisions in brief from the Factoring Regulation Act, 2011
(i) No factor shall commence or carry on the factoring business unless it obtains a certificate of
registration from the Reserve Bank to commence or carry on the factoring business under this Act.
For the removal of doubts it is hereby clarified that a non-banking financial company engaged in
factoring business shall be treated as engaged in factoring business as its “principal business” if it
fulfils the following conditions, namely:—
(a) If its financial assets in the factoring business are more than fifty per cent. of its total assets
or such per cent. as may be stipulated by the Reserve Bank; and
(b) If its income from factoring business is more than fifty per cent. of the gross income or such
per cent. as may be stipulated by the Reserve Bank.
(ii) The Reserve Bank may, if it considers necessary in the interest of business enterprises
availing factoring services or in the interest of factors or interest of other stake holders give
directions to the factors either generally or to any factor in particular or group of factors in respect
of any matters relating to or connected with the factoring business undertaken by such factors. If
any factor fails to comply with any direction given by the Reserve Bank, the Reserve Bank may
prohibit such factor from undertaking the factoring business.
The person who has to receive any amount from the debtors or who is owner of any receivable shall, at
the time of entering an agreement with the factor disclose to the factor any defences and right of set off
that may be available to the debtor. Upon entering the agreement, any security created to secure the
payment of receivable shall vest in the factor and he is eligible to exercise all the rights and remedies
whether by way of damages or otherwise which would otherwise available to the owner of receivable.
Before demanding any payment from the debtors, the factor shall give a proper notice to him. After
receiving the notice, the debtors shall make the required payment to the factor and this will fully
discharge the liability of the debtor.
In case, no notice for payment is received by the debtor, and he makes the required payment to
the owner of receivable, such amount shall be paid forthwith by him to the factor. So, the owner of
the receivable acts as a trustee in this situation and he holds the amount received from the debtor
in trust for the factor.
If any modification in the original contract takes place between the owner of receivable and the
factor, will not be binding against the factor unless he consents to it. If the owner of receivable
commits any breach of original contract with debtor, the debtor can claim any loss or damage
caused to him in consequence of that.

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Every factor shall for the purpose of registration, file the particulars of every transaction of
assignment of receivables to the Central Registry to be set up under Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002
within 30 days from the date of such assignment or from the date of establishment of such registry.
9.2 As per the Non-Banking Financial Company - Factors (Reserve
Bank) Directions, 2012
Following additional points may be noted with relation to factoring in this regard:
(i) An entity not registered with the Reserve Bank of India (RBI) may conduct the business of
factoring if it is an entity mentioned in Section 5 of the Act i.e. a bank or any corporation
established under an Act of Parliament or State Legislature, or a Government Company as
defined under section 617 of the Companies Act, 1956.
(ii) Every company seeking registration as NBFC-Factor shall have a minimum Net Owned
Fund (NOF) of ` 5 crore. Existing companies seeking registration as NBFC-Factor but do
not fulfil the NOF criterion of ` 5 crore may approach the Bank for time to comply with the
requirement.
(iii) A new company that is granted Certificate of Registration (CoR) by the RBI as NBFC-Factor
shall commence business within six months from the date of grant of CoR by the RBI.
(iv) An NBFC-Factor shall ensure that its financial assets in the factoring business constitute at
least 50 per cent of its total assets and the income derived from factoring business is not
less than 50 per cent of its gross income.

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