Factoring: Mechanism, Types and Benefits

After reading this article you will learn about Factoring:- 1. Mechanism of Factoring 2. Types of Factoring 3. Benefits.

Mechanism of Factoring:

The mechanism of factoring is summed tip as below:

(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.

The mechanism of factoring has been shown in the following figure:

Types of Factoring:

A number of factoring arrangements are possible depending upon the agreement reached between the selling firm and the factor.

However, following are some of the important types of factoring arrangements:

1. Recourse and Non-Recourse Factoring:

In a recourse factoring arrangement, the factor has recourse to the client (selling firm) if the receivables purchased turn out to be bad, i.e., the risk of bad debts is to be borne by the client and the factor does not assume the risks of default associated with receivables. The difference between recourse and non-recourse factoring is mainly on account of risk factor.

Whereas, in case of non-recourse factoring, the risk or loss on account of non-payment by the customers of the client is to be borne by the factor and he cannot claim this amount from the selling firm. Since the factor bears the risk of non-payment, commission or fees charged for the services in case of non-recourse factoring is higher than under the recourse factoring.

The additional fee charged by the factor for bearing the risk of bad debts/non­payment on maturity is called del credere commission.

2. Advance and Maturity Factoring:

Under advance factoring arrangement, certain percentage of receivables is paid in advance to the client, the balance being paid on the guaranteed payment date.

But, in case of maturity factoring, no advance is paid to the client and the payment is made to the client only on collection of receivables or the guaranteed payment date as may be agreed between the parties. Thus, maturity factoring consists of the sale of accounts receivables to a factor with no payment of advance funds at the time of sale.

3. Conventional or Full Factoring:

In conventional or full factoring, the factor performs almost all the services of factoring including non-recourse and advance factoring. It is also known as old Line Factoring.

4. Domestic and Export Factoring:

The basic difference between the domestic and export factoring is on account of the number of parties involved. In domestic factoring three parties are involved, namely, the selling firms (client), the factor and the customer of the client (buyer).

In contrast, four parties are involved in case of export or cross-border factoring. Namely, the exporter (selling firm or client), the importer or the customer, the export factor and the import factor. Since, two factors are involved in the export factoring; it is also called two-factor system of factoring.

Forfaiting:

The term forfaiting is similar to export factoring. It is a form of financing of export receivables. Forfaiting in essence means the forfeiting of the right to future payments through discounting future cash flows.

Thus the difference between forfaiting and factoring is that forfaiting provides hundred percent finance in advance against receivables whereas, in factoring only certain (usually 75 to 85) percentage of receivables is available as advance finance.

Moreover, forfaiting is purely financing arrangement whereas, factoring also includes other services such as administration of credit sales, collection of receivables, maintenance of sales ledger, etc.

Benefits of Factoring:

A firm that enters into factoring agreement is benefited in a number of ways as it is relieved from the problem of collection management and it can concentrate on other important business activities.

Some of the important benefits are outlined as under:

(a) It ensures a definite pattern of cash inflows from the credit sales.

(b) It serves as a source of short-term finance.

(c) It ensures better management of receivables as factor firm is a specialised agency for the same.

(d) It enables the selling firms to transfer the risk of non-payments, defaults or bad debts to the factoring firms in case of non-recourse factoring.

(e) It relieves the selling firms from the burden of credit management and enables them to concentrate on other important business activities.

(f) It saves in cost as well as space as it is a substitute for in-house collection department.

(g) In provides better opportunities for working capital management.

(h) The selling firm is also benefited by advisory services rendered by a factor.

Limitations of Factoring:

In spite of May services offered by factoring, it suffers from certain limitations.

The most critical fall outs of factoring include:

(i) The high cost of factoring as compared to other sources of short-term finance,

(ii) The perception of financial weakness about the firm availing factoring services, and

(iii) adverse impact of tough stance taken by factor, against a defaulting buyer, upon the borrower resulting into reduced future sales.