MODULE II

1. FACTORING
 Meaning
• Factoring is a financial service in which the business entity
sells its bill receivables to a third party at a discount in order
to raise funds.
• It differs from invoice discounting.
• The concept of invoice discounting involves, getting the
invoice discounted at a certain rate to get the funds, whereas
the concept of factoring is broader.
• Factoring involves the selling of all the accounts receivable
to an outside agency. Such an agency is called a Factor.
 Concept of Factoring
• The seller makes the sale of goods or services and generates
invoices for the same.(i)
• The business then sells all its invoices to a third party called the
factor. (ii)
• The factor pays the seller, after deducting some discount on the
invoice value.(iv)
• The rate of discount in factoring ranges from 2 to 6 percent.
• However, the factor does not make the payment of all invoices
immediately to the seller. Rather, it pays only up to 75 to 80
percent of the invoice value after deducting the discount.
• The remaining 20 to 25 percent of the invoice value is paid after the
factor receives the payments from the seller’s customers. It is called
factor reserve.
 SALIENT FEATURES OF FACTORING
(i) Credit Cover:
The factor takes over the risk burden of the client and thereby the client’s
credit is covered through advances.

(ii) Cash advances:

The factor makes cash advances to the client within 24 hours of receiving the
documents.

(iii) Sales ledgering:

As many documents are exchanged, all details pertaining to the transaction are
automatically computerized and stored.

(iv) Collection Service:

The factor, buys the receivables from the client, they become the factor’s debts
and the collection of cheques and other follow-up procedures are done by the
factor in its own interest.
 MECHANISM OF FACTORING

(i) An agreement is entered into between the selling firm and the factor
firm. The agreement provides the basis and the scope of the
understanding reached between the two for rendering factor services.

(ii) The sales documents should contain the instructions to make

payments directly to the factor who is assigned the job of collection of
receivables.

(iii) When the payment is received by the factor, the account of the
selling firm is credited by the factor after deducting its fees, charges,
interest etc. as agreed.

(iv)The factor may provide advance finance to the selling firm if the
conditions of the agreement so require.
MECHANISM OF FACTORING
 PARTIES TO THE FACTORING
•The buyer of the goods.
•The seller of the goods
•The factor i.e. financial institution.
The Buyer:
1. The buyer enters into an agreement with the seller and
negotiates the terms and conditions for the purchase of goods on
credit.
2. He takes the delivery of goods along with the invoice bill and
instructions from the seller to make payment to the factor on due
date.
3. Buyer will make the payment to the factor in time or ask for
extension of time. In case of default in payment on due date, he
faces legal action at the hands of factor.
The Seller
1. The seller enters into contract for the sale of goods on credit as
per the purchase order sent by the buyer stating various terms
and conditions.
2. Sells goods to the buyer as per the contract.
3. Sends copies of invoice, delivery challan along with the goods
to the buyer and gives instructions to the buyer to make payment
on due date.
4. The seller sells the receivables received from the buyer to a
factor and receives 80% or more payment in advance.
•5. The seller receives the balance payment from the factor
after paying the service charges.
The Factor
1. The factor enters into an agreement with the seller for
rendering factor services i.e. collection of
receivables/debts.
2. The factor pays 80% or more of the amount of
receivables copies of sale documents.
3. The factor receives payments from the buyer on due
dates and pays the balance money to the seller after
deducting the service charges.
Functions of Factor
MAINTENANCE OF SALES LEDGER:
• A factor maintains sales ledger for his client firm. An invoice is sent
by the client to the customer, a copy of which is marked to the factor.
The client need not maintain individual sales ledgers for his
customers.
• On the basis of the sales ledger, the factor reports to the client about
the current status of his receivables, as also receipt of payments from
the customers and as part of a package, may generate other useful
information. With the help of these reports, the client firm can review
its credit and collection policies more effectively.
COLLECTION OF ACCOUNTS RECEIVABLES:
•Under factoring arrangement, a factor undertakes the responsibility of
collecting the receivables for his client. Thus, the client firm is relieved of
the rigours of collecting debts and is thereby enabled to concentrate on
improving the purchase, production, marketing and other managerial
aspects of the business.
•With the help of trained manpower backed by infrastructural facilities a
factor systematically undertakes follow up measure and makes timely
demand in the debtors to pay amounts. Normally, debtors are more
responsive to demands or reminders from a factor as they would not like to
go down in the esteem of credit institution as a factor.
CREDIT CONTROL AND CREDIT PROTECTION:

• As factor maintains extensive information records (generally computerized) about the

financial standing and credit rating of individual customers and their track record of
payments, he is able to advise its client on whether to extend credit to a buyer or not and if
it is to be extended the amount of the credit and the period there-for.

•Further, the factor establishes credit limits for individual customers indicating the extent
to which he is prepared to accept the client’s receivables on such customers without
recourse to the client. This specialized service of a factor assists clients to handle a far
greater volume of business with confidence than would have been possible otherwise.

• In addition, factor provides credit protection to his client by purchasing without recourse
to him every debt of approved customers (within the stipulated credit limit) and assumes
the risk of default in payment by customers only in case of customers’ financial inability
to pay.
•At times, factors render certain Advisory Services to their clients. Thus, as a
credit specialist a factor undertakes comprehensive studies of economic
conditions and trends and thus is in a position to advise its clients of
impending developments in their respective industries. Many Factors employ
individuals with extensive manufacturing experience who can even advise on
work load analysis, machinery replacement programs and other technical
aspects of a client’s business.
•Factors also help their clients in choosing suitable sales agents/seasoned
personnel because of their close relationship with various individuals and
non-factored organizations. Thus, as a financial system combining all the
related services, factoring offers a distinct solution to the problems posed by
working capital tied in trade debts.
TYPES OF FACTORING
•A. Domestic Factoring
•Factoring can be both domestic and for exports. In domestic
Factoring, the client sells goods and services to the customer and
delivers the invoices, order, etc., to the Factor and informs the
customer of the same.

•In return, the Factor makes a cash advance and forwards a

statement to the client. The Factor then sends a copy of all the
statements of accounts, remittances, receipts, etc., to the
customer. On receiving them the customer sends the payment to
the Factor.
 Different types of Domestic 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.
4. Advance Factoring
•This could be with or without recourse. Under this arrangement, the
Factor provides advance at an agreed rate of interest to the client
on uncollected and non-due receivables. This is only a pre payment
and not an advance.
5. Under this method, the customer is not notified about the
arrangement between the client and the Factor. Hence the buyer is
unaware of factoring arrangement. Debt collection is organized by
the client who makes payment of each invoice to the Factor, if
advance payment had been received earlier.
•6. Invoice Discounting
•In this arrangement, the only facility provided by the Factor is finance. In
this method the client is a reputed company who would like to deal with its
customers directly, including collection, and keep this Factoring
arrangement confidential.

•The client collects payments from customer and hands it over to Factor.
The risk involved in invoice discounting is much higher than in any other
methods.

•The Factor has liberty to convert the facility by notifying all the clients to
protect his interest. This service is becoming quite popular in Europe and
nearly one third of Factoring business comprises this facility.
7. Bulk Factoring
•It is a modified version of Invoice discounting wherein notification of assignment of
debts is given to the customers. However, the client is subject to full recourse and he
carries out his own administration and collection.

8. Agency Factoring
•Under this arrangement, the facilities of finance and protection against bad debts are
provided by the Factor whereas the sales ledger administration and collection of debts
are carried out by the client.

9. Supplier Guarantee Factoring

•Supplier Guarantee Factoring is also known as ‘drop shipment factoring’. This
happens when the client is a mediator between supplier and customer. When the client
is a distributor, the factor guarantees the supplier against the invoices raised by the
supplier upon the client and the goods may be delivered to the customer. The client
thereafter raises bills on the customer and assigns them to the factor. The factor thus
enables the client to make a gross profit with no financial involvement at all.
•10. Bank participation factoring

•In bank participation factoring the bank takes a floating charge on the client’s equity
i.e., the amount payable by the factor to the client in .respect of his receivables. On this
basis, the bank lends to the client and enables him to have double financing.

•11. Disclosed and Undisclosed Factoring: The factoring in which the factor’s name
is indicated in the invoice by the supplier of the goods or services asking the purchaser
to pay the factor, is called disclosed factoring. Conversely, the form of factoring in
which the name of the factor is not mentioned in the invoice issued by the
manufacturer. In such a case, the factor maintains sales ledger of the client and the
debt is realized in the name of the firm. However, the control is in the hands of the
factor.
•12. Buyer-Based Factoring
•Buyer-based factoring involves factoring of all the buyer’s payables. Thus, the factor
would maintain a list of ‘approved buyers’ and any claims on such buyers (by any
seller) would be factored without recourse to the seller.
 TYPES OF FACTORING
•B. International Factoring
•Traditionally international trade is based on Letters of Credit. When the exporter knows the importer
well with repetitive transactions, he may be willing to export on ‘Open Account ‘basis. On open account
the exporter ships the goods without letter of credit or advance payment.

•Hence, it is credit risky for exporter. If credit is extended (say 90 days since), the exporter will be quite
reluctant as he encounters a credit risk and hence invariably insists on L/C.

•In advanced countries, bankers do not make much of a distinction between fund-based and non fund
based facilities and hence if they have to open L/C’s it may be at the cost of a reduced overdraft or bills
limit for the importer.

•The system of L/C’s operates on the “Doctrine of Strict Compliance” which means the L/C opening
bank will pay money to the exporter only when all the conditions listed in the L/C document are satisfied
by the exporter/shipper of goods.

•In many cases, the documents fail to pass the grade which means the exporter has simply lost the security
available to him under the L/C. Further, now-a-days, goods move very fast and hence if documents are
held up in banks for processing, it causes delay and inconvenience to the importer.
Types of International Factoring
•Two Factor Systems
•This is the most common system of international factoring and involves four
parties i.e., Exporter, Importer, Export Factor in exporter’s country and Import
Factor in Importer’s country.
The functions of the export Factor are:
•i. Assessment of the financial strength of the exporter
•ii. Prepayment to the exporter
•iii. Follow-up with the Import Factor
•iv. Sharing of commission with the import Factor

The functions of the Import Factor are:

•i. Maintaining the books of the exporter in respect of sales to the debtors in his country
•ii. Collection of debts from the importer and remitting the proceeds to the exporter’s Factor
• iii. Providing credit protection in case of financial inability on the part of any of the debtors
1. Single / Direct Factoring System
•In this system, a special agreement is signed between two Factoring
companies for single Factoring. Whereas in Two Factor System, credit is
provided by Import Factor and pre-payment, book keeping and collection
responsibilities remain with Export Factor.

•For this system to be effective there should be strong co-ordination and

co-operation between two Factoring companies. Pricing is lower when
compared to Two Factor System.

2. Direct Export Factoring

•Here only one Factoring company is involved, i.e., export Factor, which
provides all services including finance to the exporter.
3. Direct Import Factoring
•Under this system, the seller chooses to work directly with Factor of the
importing country. The Factoring agreement is executed between the
exporter and the import Factor. The import Factor is responsible for sales
ledger administration, collection of debts and providing bad debt protection
up to the agreed level of risk cover.

•4. Back to Back Factoring

•It is a very specialized form of International Factoring, used when
suppliers are selling large volumes to a few debtors for which it is difficult
to cover the credit risk in International Factoring.

•In this case, International Factor can sign a domestic Factoring agreement
with the debtor whereby it will be getting the receivables as security for
the credit risk taken in favour of Export Factor.
 ADVANTAGES OF FACTORING
•IMMEDIATE CASH INFLOW
•This type of finance shortens the cash collection cycle. It provides swift realization of
cash by selling the receivables to a factor. Availability of liquid cash sometimes
becomes a deciding factor for grabbing an opportunity or losing it. The cash boost
provided by factoring is readily available for capital expenditures, securing a new order
or meeting an unforeseen condition.

•ATTENTION TOWARDS BUSINESS OPERATIONS AND GROWTH:

•By selling off invoices, business managers can feel stress-free of the task of collection
from the customers. Resources employed in the receivables department can be directed
towards business operations, financial planning, and future growth.
•EVASION OF BAD DEBTS
•Factoring is of two types – with recourse and without recourse. Under without recourse
factoring, in case of bad debts, the loss is borne by the factor. Hence, the seller is under
no obligation to the factor once it sells off its receivables.
•SPEEDY ARRANGEMENT OF FINANCE
•Factors provide funds more rapidly than banking companies. Factoring companies
offer quicker application, lesser documentation and swifter realization of funds as
compared to other financial institutions.
•NO REQUIREMENT OF COLLATERAL
•The advances are extended on the basis of the strength of accounts receivables and
their credit healthiness. Unlike cash credit & overdraft, factors do not require any
collateral security to be pledged/hypothecated. New businesses, startups can easily
avail the advances provided they have strong receivables.

•SALE NOT LOAN

•Factoring transaction is a transaction of sale, not a loan. Unlike other types of
finances, factoring does not result in an increase in liabilities of the business.
Hence, there are no adverse impacts on the financial ratios as well. It just involves
the conversion of book debts into liquid cash.
 •CUSTOMER ANALYSIS
•Factors provide valuable advice and insights to the seller regarding the credit strength of
the party from whom receivables are pending. It helps in negotiating better terms between
the parties in future contracts.
•REDUCED CURRENT LIABILITIES
•The amount received from the factoring is used to pay off the bank borrowing and other
current liabilities comprising trade creditors. As a result, current liabilities are
considerably reduced. The liquidity position of the firm is strengthened further.

•OFF-BALANCE SHEET FINANCE

•When the factor purchases the clients’ debts, the finance is provided off the balance
sheet. In recourse factoring, the finance appears in the client’s balance sheet only as a
contingent liability. In recourse factoring, if the customer defaults in payment, the client
has to make good the loss incurred by the factor. The factor is entitled to recover from
the client the amount paid in advance.

• But in case of non-recourse factoring, the finance provided does not appear anywhere
in the financial statements of the borrower. The factor does not have the right of
recourse.
•CREDIT STANDING

• With increased cash flows to the client, he is able to meet his liabilities promptly
as and when they arise. The factor’s acceptance of the client’s receivables itself
is the mark of high quality of the receivables factored. The problem of bad debts
does not arise.
DISADVANTAGES OF FACTORING
•REDUCTION OF PROFIT
•The factor deducts a certain discount from the value of accounts receivable as fees for the
services offered. Moreover, in certain cases, the factor also charges interest on the advance
made. Consequently, profit of an entity is reduced by a significant margin.

•RELIABILITY OF CUSTOMER’S CREDIT

•The factor assesses and evaluates credit wellness of the party who owes bills receivables.
This is a critical factor which is outside the control of the seller. A factor may refuse to
extend advances due to poor credit ratings of the concerned party.
•EXHAUSTING OF COLLATERAL SECURITY
•Factoring exhaust bills receivables of an entity as the entity is no longer entitled to receive
payments from them. The seller is no longer holding any control over the book debts.
Hence, they can not be provided as collateral security while obtaining any other type of
finance.
 DISADVANTAGES OF FACTORING

•PRESENCE OF CONTINGENT LIABILITY

•The liability of the seller is not completely waived in case of with recourse factoring. If a
party fails to pay its debts to the factor, the factor is legally entitled to recover it from the
seller. Thus, the seller is contingently liable to the factor for paying the debts in future in case
of default. This situation would impact business operations and financial plans which are
under execution.

•HIGHER FINANCE CHARGES

•Factors usually deduct 2% to 4% of the total amount involved as their fees for the duration
of 45- 60 days. Computing it annually, the cost of finance turns out to be around 18% to 24%
p.a. which is very higher than other sources of finance.
•LOSS OF PERSONAL TOUCH
•The buyer may not be willing to deal with a factor because of their professional nature and
stringent methods. Factoring agencies even send notices at regular intervals to the buyer as a
reminder of the debt. The buyer may develop a negative image of the seller through factoring.
Loss of personal touch may lead him to consider switching vendors.
 COMMON PROBLEMS WITH FACTORING INVOICES
•1. The customer is not creditworthy

•This is the most common problem when trying to factor receivables. If the customer is not
creditworthy, the invoice isn’t factorable. Unfortunately, there is little that can be done about this
since the creditworthiness of the customers is the cornerstone of factoring.

•2. The invoice exceeds the credit line

•This common problem occurs when the total amount of the invoices that the client want to factor
exceeds the credit line that the provider has assigned to the customer. It’s always a good idea to
review and manage the status of the line proactively so that one can anticipate this problem. The
solution is to try to negotiate a credit line increase.

•3. The invoice can’t be verified

•Most factoring companies will verify invoices prior to funding. This step allows them to verify
that the work has been completed satisfactorily – or that the product has been delivered in
accordance with the purchase order. It also helps you ensure that the clients are happy. However,
customers can refuse to verify an invoice at their discretion. And if they do, the provider may not
factor that invoice.
 COMMON PROBLEMS WITH FACTORING INVOICES
•4. The customer refuses to submit payment to the factoring company

•As part of the financing process, the customer must submit the invoice payment directly to the
factoring company. This process is usually outlined in the notice of assignment letter that is sent
to them. For whatever reason, the customer could refuse to send the payment to the factor. This
situation can be very problematic and could prevent factor from financing the invoices
associated with that customer.

•5. The work is not complete / the product is not delivered

• This is the most common problem when factoring invoices. Usually the client tries to factor
an invoice for which the service has not been completed or the product has not been fully
delivered. This invoice will be un-factorable until the work is completed or the product is
delivered. Factoring companies can only purchase invoice for completed services.