Interdisplinary Journal of Research and Development “Alexander Moisiu“ University, Durrës, Albania
Vol (I), No.2, 2014
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RESEARCH ARTICLE
FACTORING: A FINANCIAL INSTRUMENT
Ulpian HOTI
Chancellor
“Aleksandër Moisiu”, University Durrës
[Link]@[Link]
Abstract
Factoring is a three-party transaction. In consideration of a commission (also known as a
discount fee), on an ongoing basis, the factor’s client sells to the factor current (not overly aged)
accounts owed to the client by third-party customers (account debtors), arising from goods sold
or services rendered by the client to the account debtor. Depending on the form of factoring
chosen, the factor may finance its client by making a cash advance to the client on the date of
purchase of the subject accounts.
The paper is aimed to give an overview of factoring and will give a brief of its historical
development. The paper will focus on the meaning of the factoring as a financial instrument, its
classification and the advantages/disadvantages of it.
Keywords: Factoring, financial instrument, classification, benefits.
Introduction which receivables arising out of sale of goods/
Factoring is used in developed and developing services are sold to the “factor” as a result of which
countries around the world. In some developed the title to the goods/services represented by the said
economies such as the United States, its importance as receivables passes on to the factor. Hence the factor
a primary source of working capital finance tends to becomes responsible for all credit control, sales
be concentrated in selected industries. In other accounting and debt collection from the buyer(s).
developed economies, its importance as a primary
source of working capital appears to be much more Historical view of factoring
widespread. Factoring in the modern sense of the word can be
The global pattern of factoring suggests that it may traced in lang syne. First evidences of existing
have an advantage compared to other types of lending, factoring appear 4.000 years ago in the acient
such as loans collateralized by fixed assets, under civilization of Mesopotamia, during the region of king
certain conditions. Factoring is quite distinct from Hammurabi1, some of its tracks are located in the
traditional forms of commercial lending where credit Roman empire2. First terminology for agents and
is primarily underwritten based on the factors appears in the 15th century in trade settlements
creditworthiness of the seller rather than the value of organized by European traders in the colonial
the seller’s underlying assets. In a traditional lending countries where they were buying goods. It was a
relationship, the lender looks to collateral only as a primitive type of factoring, which initially had the
secondary source of repayment. The primary source of form of commission sales because factors,
repayment is the seller itself and its viability as an guaranteeing their clients that, buyers will pay goods
ongoing entity. or that they will pay in advance before the ultimate
The development of factoring concept in various buyer pays to them. As a special form of financing,
developed countries of the world has led to some factoring is being developed in the late 19th century,
consensus towards defining the term. Factoring can on the Anglo- American territory, and especially in
broadly be defined as an arrangement in
1
Ivanovic, Sasa, Suzana Baresa, and Sinisa Bogdan. 2011.
Factoring: Alternative model of financing. UTMS Journal of
Economics 2 (2): p.192.
2
Ibid
7
Factoring: a financial instrument... U. Hoti
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the textile industry, where 95% of turnover was done 1. To trade or professional debtors
was done by factoring. 2. Across national boundaries
Through history, factoring evolved and took different 3. When notice of assignment has been given to the
forms and adapted for the needs of participant in the debtors.
factoring business—first, business entity–client, Factoring may broadly be defined as the relationship,
second, factor, third, buyer–debtor, on the created by an agreement, between the seller of
international level fourth, correspondingly factoring goods/services and a financial institution called .the
company in the country of the debtor, special factor, whereby the later purchases the receivables of
activities, general economic and political situation and the former and also controls and administers the
circumstances, that resulted with various forms and receivables of the former. Factoring may also be
types of factoring, which is applied today in business defined as a continuous relationship between financial
practice. institution (the factor) and a business concern selling
goods and/or providing service (the client) to a trade
The Meaning Of Factoring customer on an open account basis, whereby the factor
Factoring is a contemporary and specific form of purchases the client’s book debts (account
short-term financing based on the selling short–term receivables) with or without recourse to the client,
unsecured assets of the company to a specialized thereby controlling the credit extended to the customer
financial organization or company that specializes in and also undertaking to administer the sales ledgers
factoring (factor) to pay certain fees or charges. In relevant to the transaction.
other words, factoring is the purchase of others' claims
(debts) that is a financial instrument that factor Classification Of Factoring
(factor-house, factor-company, factor-organization, a Following are some of the important types of factoring
bank that has a separate department) financed by the arrangements:
business entity on the basis of future (outstanding) Recourse and Non-recourse Factoring
claims arising from the sale of goods or services on In a recourse factoring arrangement, the factor has
the domestic or foreign market for a fee. recourse to the client (selling firm) if the receivables
The factor buys the receivables for a fee before the purchased turn out to be bad, Let the risk of bad debts
expiry date of payment, takes over the activities of is to be borne by the client and the factor does not
collection, warnings, account transactions and the risk assume credit risks associated with the receivables.
of collection of receivables3. At a time when it charge Thus, the factor acts as an agent for collection of bills
more than the discounted price which he paid for the and does not cover the risk of customer’s failure to
purchased receivables, the factor profits4. pay debt or interest on it. The factor has a right to
The term “factoring” has been defined in various recover the funds from the seller client in case of such
countries in different ways due to non-availability of defaults as the seller takes the risk of credit and
any uniform codified law. The study group appointed creditworthiness of buyer. The factor charges the
by International Institute for the Unification of Private selling firm for maintaining the sales ledger and debt
Law (UNIDROIT)5, Rome during 1988 collection services and also charges interest on the
recommended, in simple words, the definition of amount drawn by the client (selling firm) for the
factoring as under: “Factoring means an arrangement period.
between a factor and his client which includes at least Whereas, in case of non-recourse factoring, the risk or
two of the following services to be provided by the loss on account of non-payment by the customers of
factor: the client is to be borne by the factor and he cannot
[Link] claim this amount from the selling firm. Since the
[Link] of accounts factor bears the risk of non-payment, commission or
[Link] of debts fees charged for the services in case of nonrecourse
[Link] against credit risks. factoring is higher than under the recourse factoring6.
The above definition, however, applies only to Advance and Maturity Factoring
factoring in relation to supply of goods and services in Under advance factoring arrangement, the factor pays
respect of the following: only a certain percentage of the receivables in advance
to the client, the balance being paid on the guaranteed
3
payment date. As soon as factored receivables are
Markovic, Ivan. 2000. Financiranje: Teorija i praksa approved, the advance amount is made available to the
financiranja trgovackih drustava. Zagreb: RRIF. p.58
4
Ivanovic, Zoran. 1997. Financial management. 2. ed. Opatija: 6
University of Rijeka, p. 261 Sopranzetti, B. J., 1998. The economics of factoring
5
See UNIDROIT website [Link] /english/ accounts receivable. Journal of Economics and Business 50,
implement/[Link]#NR11 339-359.
8
Interdisplinary Journal of Research and Development “Alexander Moisiu“ University, Durrës, Albania
Vol (I), No.2, 2014
__________________________________________________________________________________________________
client by the factor. The factor charges Better conditions for new customers (it is important
discount/interest on the advance payment from the for the export companies)
date of such payment to the date of actual collection of Reducing the risk (bad debts are eliminated in the
receivables by the factor. The rate of discount/interest non-recourse factoring)
is determined on the basis of the creditworthiness of Reducing the credit risk in dealing with customers
the client, volume of sales and prevailing short-term and increased profitability
rate. Disadvantages
Conventional or Full Factoring Over-reliance on a factoring company can result in
Under this system the factor performs almost all excessive trading and mismanagement.
services of collection of receivables, maintenance of Over-reliance on a factoring company can also
sales ledger, credit collection, credit control and credit result in loss of direct customer relations.
insurance. It is also known as Old Line Factoring. Some types of company are not attractive for
Number of other variety of services such as maturity- factoring, such as small low-volume companies,
wise bills collection, maintenance of accounts, companies whose accounts receivable originate from
advance granting of limits to a limited discounting of only a few customers, companies with many small
invoices on a selective basis are provided. In advanced customers, companies with speculative business.
countries, all these methods are popular. Factoring costs are normally higher than those of
Limited Factoring bank loans, so the price of the final product will be
Under limited factoring, the factor discounts only
higher as well.
certain invoices on selective basis and converts credit
Exporters must insure there are no disagreements
bills into cash in respect of those bills only.
with buyers over product quality.
Selected Seller Based Factoring
Some buyers do not like parties other than the
The factor performs all functions of maintaining the
seller to be involved.
accounts, collecting the debts, sending reminders to
the buyers and does all consequential and incidental Factoring is short-term financing and cannot meet
functions for the seller. The sellers are normally all business needs7.
approved by the factor before entering into factoring Factoring occurs only when the factor is quite sure
agreement. of the client's solvency.
Selected Buyer Based Factoring Factoring companies prefer customers with larger
The factor first of all selects the buyers on the basis of businesses.
their goodwill and creditworthiness and prepares an
approved list of them. The approved buyers of a Conclusions
company approach the factor or discounting their Factoring is one of the oldest and most common
purchases of bills receivables drawn in the favor of the methods of receivables financing.
company in question. The factor discounts the bills Factoring is explicitly linked to the value of a
without recourse to seller and makes the payment to supplier’s accounts receivable and receivables are
the seller. sold, rather than collateralized, and factored
Advantages and disadvantages of factoring as a receivables are not part of the estate of a bankrupt
financial instrument firm.
Advantages Factoring may allow a high-risk supplier to transfer its
Availability of funds, as opposed to short-term credit risk to higher quality buyers.
bank credits factors consider sales invoices as safe Some advantages of factoring include:
asset, while banks consider fixed asset as safety - No time wasted on comprehensive loan applications
Less time in the realization of factoring application -Better cash flow and quicker access to working
process and fund insurance through factoring is much capital
more faster, than it takes time to establish a line of -Better liquidity through on-time cash injections
credit through short-term bank credit lines (advances from the factor)
Better cash flow and faster access to liquid capital -Better financial standing, creditworthiness, and
solvency
Better financial position, credit worthiness and
Operating expenses reduced (for the reasons listed
solvency
above)
Improving the reputation, the growth of credit
standing because of liquidity improve and timely
execution of liabilities, the company has a reputation 7
as a reliable-increases sales and competitiveness Klapper, Leora. 2005. The role of factoring for financing
small and medium enterprises. World Bank Policy Research
Working Paper 3593. NW: World Bank, p.3596.
9
Factoring: a financial instrument... U. Hoti
________________________________________________________________________________________________
Even a start-up or young company can obtain 3. Klapper, Leora. 2005. The role of factoring for
financing quickly financing small and medium enterprises. World Bank
Better information management (especially under Policy Research Working Paper 3593. NW: World
full factoring) Bank.
Factoring is larger in countries with greater economic 4. Markovic, Ivan. 2000. Financiranje: Teorija i
development and growth and developed credit praksa financiranja trgovackih drustava. Zagreb:
information bureaus. RRIF.
Factoring may also be particularly attractive in 5. Sopranzetti, B. J., 1998. The economics of
financial systems with weak commercial laws and factoring accounts receivable. Journal of Economics
enforcement. and Business 50, 339-359.
Like traditional forms of commercial lending, 6. UNIDROIT website [Link]
factoring provides small and medium enterprises english/ implement/[Link]#NR11
(SMEs) with working capital financing. However,
unlike traditional forms of working capital financing,
factoring involves the outright purchase of the
accounts receivable by the factor, rather than the
collateralization of a loan.
The virtue of factoring in a weak business
environment is that the factored receivables are
removed from the bankruptcy estate of the seller and
become the property of the factor.
Bibliography
1. Ivanovic, Sasa, Suzana Baresa, and Sinisa
Bogdan. 2011. Factoring: Alternative model of
financing. UTMS Journal of Economics 2 (2): 189–
206.
2. Ivanovic, Zoran. 1997. Financial management. 2.
ed. Opatija: University of Rijeka.
10