Factoring - Working Capital Management

FACTORING

1History

2Modus of Operations

3Mechanics of Factoring

4 Types Of Factoring

5 Difference between Factoring And Forfeiting

Factoring

Factoring is a service of financial nature involving the conversion of credit bills into cash. Accounts receivables, bills recoverables and other credit dues resulting from credit sales appear, in the books of accounts as book credits. Here the risk of credit, risk of credit worthiness of the debtor and as number of incidental and consequential risks are involved. These risks are taken by the factor which purchase these credit receivables without recourse and collects the m when due. These balance-sheet items are replaced by cash received from the factoring agent.

1History

Roman

Factoring has not been documented as having been used by the Romans. However, the word ‗factoring‘ has a Roman root. It is derived from the Latin verb ‘facio‘ which can be translated as ―he who does things‖. In Roman times this referred to agent of a property owner, i.e., his business manager. Though the root word has nothing to do with the industry, as they attempt to help their clients thro ugh their financial problem.

Factoring in United States

Factoring arose in the United States during 19th century, as direct result of the inability of manufacturers to ma intain consta nt and timely communications with their sales forces in the field. At that time, as the case today, the sales force was paid by communications. If all sales were at the risk of the manufacturer, the salesman had no incentive to exercise prudence in connection with whom to sell to on credit.

On the other hand, the distant manufacturer was not in the position to make the credit risk on sales. The risk of defective or non-conforming merchandise remained with the manufacturer. The credit risk was now separated from disputes as to quality, work mans hip and conformity of goods. Soon after, the salesman began to act as independent sales agencies. It was common for them to act for more than one manufacturer. Still later the sales function was separated from the credit function and ―Traditional Factoring‖ as the people know, it had, at that point, developed in the United States.

History Factoring in India

Banks provide generally bill collection and bill discounting and with recourse. They provide working capital finance based on these bills classified by a mounts maturity wise. Such bills if accumulated in large quantities will burden the liquidity and solvency position of the company and reduces the credit limits from the banks. It is therefore felt necessary that the company assigns these book debts to a factor for taking them off from the balance sheet. This reduces the workload, increases the solvency and improves the liquidity position of the company.

Vaghul Committee report on money market reforms has confirmed the need for factoring services to be developed in India as part of the money market instruments. Many new instruments were already introduced like Participation certificates, Commercial papers, Certificate of deposits etc., but the factoring service has not developed to any significant extent in India.

The Reserve Bank allowed some banks to set up subsidiaries on a zonal basis to take care of the require me nts of companies in need of such service. Thus Canara Bank, State Bank of India, Punjab National Bank and a few other banks have been permitted to set up jointly some factor, for Eastern, Western, Northern, and Southern Zones. The progress of the activity did not show any worth while dime ns ion, so far.

2Modus of Operations

If a company wants to factor its receivables it submits a list of customers, their credit rating, a mount involved in maturity and other terms. If the factor scrutinizes the list of buyers and they are in the approved list, the factor gives its decision of the clients and the a mounts they may take all receivables on wholesale discounting basis. The factor the n takes all the documents in respect of approved list and pays up to 80% to 90% of the a mount due less commission to the company which in turn removes these instruments, from base of accounts and shows cash flow as against bills receivables written off.

Factoring  services  re nde re d the following services:

 Purchase  of book debts and  receivables.

 Ad ministration  of sales ledger  of the  clients.

 Prepayments  of debts  partially  or  fully.

 Collection  of book  debts  or  receivables  or  with  or  without documents.

 Covering the credit risk of the suppliers.

 Dealing in  book  debts of customers without recourse.

Why Factoring?

 Factoring is one of the most important and unavoidable part of the business concern which meets the short-term financial requirement of the concern. Factoring is favorable to the industrial concern for the following reasons.

1 .Quickest response–Customer oriented timely decisions and decision on sanction within a week.

2. Low cost.

3. Low service charges (0.1% to 0.3%).

4. Low margin (20% onwards).

5. Instant finance–against each invoice.

6. Generous grace period.

7. Improves cashflow.

8. Substitutes sundry creditors.

9. Increases sales through better terms on sales.

10. More operating cycles and more profits.

11. No upfront recovery of charges.

12. Interest on daily products.

13. Very easy to operate.

14. Flexible credit periods.

15. No penal interest up to grace period.

16. Empowers cash purchase.

17. Improves credit reputation.

18. Follow up of each invoice.

19. Collection of receivables.

20. MIS reports like customers overdue invoices enabling constant evaluation of customers.

21. Outstation payments at nominal rates.

3 Mechanics of Factoring

The  following are the steps for factoring:

 The customer places an order with the seller (client).

 The factor and the seller enter into a factoring agreement about the various terms of factoring.

 Sale contract is entered into with the buyer and the goods are delivered.

The invoice with the notice to pay the factor is sent alongwith.

 The copy of invoice covering the above sale to the factor, who maintains the sale ledger.

 The factor prepays 80% of the invoice value.

 The monthly statement are sent by the factor to the buyer.

 Follow up action is initiated if there are any unpaid invoices.

 The buyer settles the invoices on the expiry of the credit period allowed.

 The balance 20% less the cost of factoring is paid by the factor to the client.

4 Types Of Factoring

 Notified factoring

Here, the customer is intimated about the assignment of debt to a factor, also directed to make payments to the factor instead of to the fir m. This is invariably done by a legend and the invoice has been assigned to or sold to the factor.

 Non-notified or confidential factoring

Under this facility, the supplier/factor arrangement is not declared to the customer unless or until there is a breach of the agreement on the part of the client, or exceptionally, where the factor considers himself to be at risk.

 With re course or without re course factoring

Under recourse arrangements, the client will carry the credit risk in respect of debts sold to the factor. In without recourse factoring, the bad debts are borne by the factor.

 Bank Participation Factoring

The client creates a floating charge on the factoring reserves in favour of banks and borrow against these reserves.

 Ex port Facto ring

There is usually the presence of two factors: an export factor and an import factor. The former buys the invoices of a client exporter and assumes the risk in case of default by the overseas customers. Because of distance, different condition or lake of information, the export factor usually forms out to an agent, known as the import factor, the administrative job of servicing the debts owed to its exporting clients.

5 Difference between Factoring And Forfeiting

The following are differences between factoring and forfeiting