Factoring of Book Debts: Meaning and Types

In this article we will discuss about:- 1. Meaning of Factoring 2. Factoring Mechanism 3. Functions of a Factor 4. Types of Factoring 5. Benefits of Factoring 6. Cost-Benefit Analysis of Factoring 7. Factoring and Financial Statements.

Meaning of Factoring:

Factoring is a method of financing whereby a firm sells its trade debts at a discount to a financial institution. In other words, factoring is a continuous arrangement between a financial institution, (namely the factor) and a firm (namely the client) which sells goods and services to trade customers on credit.

As per this arrangement, the factor purchases the client’s trade debts including accounts receivables either with or without recourse to the client, and thus, exercises control over the credit extended to the customers and administers the sales ledger of his client. To put it simply, a factor is an agent who collects the dues of his client for a certain fee.

The dictionary meaning of ‘factoring’ is ‘the work of a factor’, the business of buying up trade debts or lending money on the security of trade debts. Factoring may be defined as a contract by which the factor is to provide at least two of the services i.e., finance, the maintenance of accounts, the collection of receivables and protection against credit risks.

The supplier is to assign to the factor on a continuing basis, by way of sale or security, receivables arising from the sale of goods or supply of services. Factoring is a specialized activity whereby a firm converts its receivables into cash by selling them to a factoring organization. The factor assumes the risk of collection and in the event of non-payment by the customers/debtors bears the risk of bad debt losses.

It is also termed as ‘invoice factoring’ as factoring covers only those receivables which are not supported by negotiable instruments, namely, bills. In case of receivables backed by bills, the firm resorts to the practice of bill discounting with its bankers. With the factoring of receivables, the client dispenses away the credit department and the debtors of the firm becomes the debtors of the factor.

Factoring Mechanism:

In the normal course of business, transactions of credit sales generate the factoring business. Realization of credit sales is the main function of factoring firm. Once a sale transaction is completed and the invoice is raised on the buyer, the factor is approached by the seller to realize the bill amount from the buyer of goods or services.

A general view of factoring mechanism explaining the steps taken by the different parties and flow of information between them is outlined below:

(a) Sells goods to the buyer as per the terms of agreement and invoices him in the usual way- only inscribing an instruction to the effect that the invoice is assigned to the factor and payment should be made to the factor.

(b) Hands over copies of invoices, delivery challan to the factor under cover of a schedule of offer, Lorry receipts or Railway receipts (The seller should not raise a bill of exchange on the buyer).

(c) The factor makes payment upto 80 per cent of the value of the assigned invoice.

(d) The seller will receive balance payment from the factor after the deduction of factor’s service charges etc. after the buyer makes payment for the invoice, the factor.

Factor:

(a) Based on the credit evaluation of the seller and the customers who purchase his goods, the factor enters into an agreement with the seller for rendering factoring services to him.

(b) On receipt of copies of sale invoices and receipted delivery challans as referred to above, factor pays the seller up to 80% of the price of the goods supplied by him to the buyer.

(c) The factor generally receives payment from the buyer on due dates and pays the balance 20% of the price to the seller after deducting his commercial charges.

(d) The factor enters into an agreement with the seller, if he satisfies the following conditions:

(i) The invoice, bills or other documents drawn by the seller should contain a clause that payments arising out of the sale transaction may be factored.

(ii) The seller should confirm in writing to the factor that all the payments arising out of these bills are free from any encumbrance, charge, lien or right of set-off, or counter­claim from any other person.

(iii) The seller should execute a deed of assignment in favour of the factor to enable him to recover the payment from the buyer.

(iv) The seller should procure a letter of waiver/letter of comfort from seller’s bank in favour of the factor or disclaimer certificate in case the bank has a charge over the assets sold out to the buyer and the sale proceeds are to be deposited in the account of the bank.

(v) The seller can sell goods to the buyers approved by the factor upto the limit fixed by the factor for each buyer.

(vi) The rate of interest payable by the seller to the factor should be fixed for the advances given by the factor.

Buyer of Goods or Services:

(a) Buyer approaches the seller and finalizes the terms of purchasing the goods from the seller such as price, delivery date, credit period, etc.

(b) Buyer receives delivery of goods with invoice. The invoice contains instructions by the seller to make payment to the factor on the due date.

(c) Buyer makes payment to factor in time or gets extension of time from the factor.

Functions of a Factor:

Depending on the type of factoring, the main functions of a factor are:

i. Collection of Receivables:

The factor collects the receivables on behalf of his client and relieves him from the botheration of the problems involved in collection work. This helps the client to concentrate on production. Debtors are more responsive to the demands from a factor being a credit institution. Collection of receivables is the most important function of a factor.

ii. Sales Ledger Management:

Sales ledger management is very important in certain types in factoring. Once the factoring relationship is established, it becomes the factor’s sales ledger. The factor has to credit the customer’s account whenever payment is received, send periodical statements to the customer and maintain liaison with the clients and the buyers of goods to resolve all possible disputes.

He has to inform the client about the balances in the account, the overdue bills, the financial standing of the buyers, etc. Thus, the factor takes up the work of monthly sales analysis, overdue invoice analysis and credit analysis.

iii. Financing of Trade Debts:

The most important feature of factoring is that a factor buys the book debts of his client and the debts are assigned to him. The factor advances upto 80% of the assigned debts to his client.

If the debts are factored with recourse and in case buyer fails to pay the bill on the due date, he has to refund the advance given by the factor. If the debts are factored without recourse the factor has to bear the loss if buyer defaults in payment of the bill on the due date.

iv. Credit Investigation and Undertaking of Credit:

The factor has to monitor the financial position of the buyers since he assumes the risk of default in payment by buyers on account of their financial inability to pay. This assumption of credit risk is one of the most important functions which the factor accepts.

Hence, before accepting the risk, he must be fully aware of the financial viability of the buyers, their financial health, honesty and integrity in the business world etc. For this purpose, the factor also undertakes credit investigation work.

Types of Factoring:

i. Notified Factoring:

In the case of notified factoring, the customer is intimated about the assignment of debt to the factor and also directed to make payments to the factor instead of the firm. This is invariably stated on the face of the invoice that the receivables arising out from the invoice has been assigned to the factor.

ii. Non-Notified or Confidential Factoring:

This facility is one under which 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 supplier or, exceptionally, where the factor considers himself to be at risk.

iii. Factoring with Recourse/Without Recourse:

Whether notified or not, can be further classified as with recourse and without recourse factoring. Under with recourse arrangement, the supplier will carry the credit risk in respect of receivables he has sold to the factor. The factor will have recourse in the event of non-payment for whatever reason, including the financial inability of the customer to pay.

Effectively the factor has the option to sell back to the supplier any receivables not paid by a customer regardless of the reason for non-payment. In without recourse factoring the bad debts are borne by the factoring agent or factor. However, the factor commission would be higher in without recourse factoring. With recourse factoring is similar to bills discounting scheme.

iv. Credit Factoring (or Invoice Discounting):

The factor purchases book debts with recourse to the seller and provides finance, interests is charged until the bill amount is collected from the buyer of goods. All work connected with sales administrations, collection of dues have to be done by the client himself.

v. Debt Administration Factoring (or Maturity Factoring):

It involves no financing. The service provided is purely administrative. The factor will administer the sales ledger and forward the invoice to the buyer and collect debt on the due date.

vi. Bulk Factoring:

This is only a variation of invoice discounting in which finance is provided by the factor only after the assignment of debt is notified by the seller to the debtor with instructions to make payment to the factor.

vii. Bank Participation Factoring:

In bank participation factoring, the supplier creates a floating charge on the factoring reserves in favour of banks and borrow against these reserves. For instance, if factor reserve is 20 per cent, the supplier firm can borrow to the extent of 80 per cent, of this reserve from bank, thereby reducing its investments on receivable.

viii. International Factoring:

This deals with export sales. The factoring service may include completing legal and procedural formalities pertaining to export.

Benefits of Factoring:

The benefits of factoring as under:

(a) The factor performs basic functions like administration of seller’s sales ledger, credit control, collection of dues etc. This would save the administration costs.

(b) The factor by providing payment on the purchase of receivables contrasts the length of operating cycle period and reduces the working capital needs. This would save the interest on capital.

(c) The improved liquidity position enables the firm to honour its obligations without any delay. The improved credit standing helps the firm to get the benefits of lower purchase price, longer credit period from suppliers, trade discount on bulk purchases, cash discount on early payment, better market standing, quicker sanction of loans and advances, better terms and conditions while borrowing, etc.

(d) By shifting the functions associated with credit management, the firm saves time and energy to concentrate more on managerial functions like planning, organizing, control, etc. Better planning, improved employee morale, quality products, improved marketability, lower advertisement costs etc. are the benefits.

(e) The factor on account of his experience and specialization advises the firm on critical areas like product design, production methods, product-mix, marketing-mix, machinery replace­ment, technology use etc. These advises would go a long way in minimizing the various costs.

(f) As there is reduction in bank borrowings, factoring transaction will result in a desirable improvement in the current ratio after factoring is done.

(g) The seller is relieved from the botheration of collecting the debts. He has more time to concentrate on production, purchase of raw materials and sale of the goods produced by him.

(h) The seller assigns his debts to the factor and gets prepayment. So, the purchase of debts by the factor will be off the balance sheet and will appear as contingent liability in case the transaction is with recourse factoring. In the case of full service factoring (i.e. without recourse factoring) it will not appear even as a contingent liability in the balance sheet.

(i) Finance available to the seller of goods from the factor (who pays 80% advance) increases with the increase in sales. Therefore, the problem of additional working capital needs to match the increase in sales turnover does not generally arise. This helps in better working capital management.

Cost-Benefit Analysis of Factoring:

Factoring services have both costs and benefits. The costs of factoring are:

(a) Interest on advance extended by the factor.

(b) Commission/fee for his services.

In the USA, the maximum advance a factor provides is equal to the amount of factoring receivables less the sum of (i) the factoring commission, (ii) interest on advance, and (iii) reserve that the factor requires to cover bad debts losses. The amount of reserve depends on the quality of factored receivables and usually ranges between 5 to 20%. Further, interest rate ranges between 2 to 5% over and above the prime rate of interest.

The commission is usually charged in the range of 2.5% to 3% on the gross value of invoices. In fact, the factoring commission will depend on the total volume of receivables, the size of individual receivables and the quality of receivables.

The commission is expected to be higher for without- recourse factoring, since the factor assumes the entire credit risk. A concern has to evaluate costs and benefits to arrive at a decision regarding the use of factoring services with the aid of numerical computation.