Subject. PAPER No. : Financial Management MODULE No. : Factoring services

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1 Subject Paper No. and Title Module No. and Title Module Tag Paper No.8: Financial Management Module No. 36: Factoring services COM_P8_M36

2 TABLE OF CONTENTS 1. Learning outcomes 2. Introduction 3. Mode of operating 4. Features of factoring 5. Nature of factoring 6. Factoring services 7. Types of factoring 8. Benefits and costs of factoring 8.1 Costs of factoring 9. Suitability of factoring 10. Factoring vs. bills discounting 11. Factoring vs. short-term financing 12. Practical problems on factoring 13. Summary

3 1. Learning Outcomes After studying this module, you shall be able to: Explain the meaning, nature and features of factoring Discuss the mode of operating of factoring Focus on various types of services offered by factoring organizations Elaborate the different types of factoring Emphasize on costs, benefits and suitability of factoring Differentiate factoring with bills discounting and other short-term financing sources 2. Introduction In case of trading and manufacturing firms, a lot of working capital is tied in the operating cycle in the form of trade debts. The collection of such debts is very difficult and requires lot of time. Factoring is the financing given to such trading and manufacturing firms by purchasing trade debts and helping in their collection. It is generally done by banks and specialist organizations known as factoring organizations. 3. Mode of Operating Three parties are generally involved in factoring agreements: i. Factor who is the agent of the factoring organizations or banks. ii. Client the company who gets finance by selling the debt. iii. Customer to whom company sells goods on credit. Thus, factor helps in converting credit sales into cash sales and generating finance. Before client sells his goods on credit, he makes the contract of factoring with factor specifying rules and regulations. Then client sends customer s order to factor. Factor evaluates the credit worthiness of the customer and approves it. Then client sells his goods on credit and debt is generated. The client gets 100% finance from factor on selling his debt and debtors have to make the payment to the factor only. This is the most common factoring contract. In some other cases factor gives only 80% of the debt amount and rest 20% is given on receiving payment from debtors. The factor charges fees from the client which is called factoring charge which includes: (a) Service Charge It is charged for the services of the factor. (b) Interest Payment It is the interest on the financing amount at the prevailing bank rate of interest. In India, it ranges between 2.5% to 3%. In case of bad debt, factor may come to client (with recourse) or bear loss himself (without recourse) which depends on type of contract. 4. Features of Factoring Main features of a factoring arrangement are as follows:

4 1. Factor determines the clients with whom he wants to deal and also fixes the credit limit they can grant. 2. Factor provides money against the debts which is generally 70-80% of debt amount and charges a charge for it. 3. Factor makes the full payment of debt on debt maturity or when debt amount is collected, whichever is earlier. 4. Factoring organizations charges a commission (i.e. 1-2%) of the debt factored. 5. Nature of Factoring Factoring has three different aspects. It is a financial function as it helps in providing finance against debt, thus helps in overcoming the cash crunches. It is a management function also as it helps in effective management of assets. It helps to convert non-productive assets (debtors) into productive assets (cash). Factoring has a legal aspect also. It specifies a legal relationship between the client and factor which has certain clauses legally binding on both the parties. 6. Factoring Services Apart from performing the basic function of financing against debts, a factor also renders a number of services which are as follows: 1. Financial Assistance (Purchase and Financing of Debt):It is the most common/basic function of factoring where the factor purchases the debt and provides finance against it, i.e. provides liquidity to the client. 2. Credit Administration: A factor helps the client in assessing the credit worthiness of a customer before granting credit. He also assists in deciding the maximum amount of credit to be granted to a customer. He also maintains an account of all the customers for timely collection of debts. He provides latest trends and information about market, competitors, customers, etc. He also prepares a number of reports relating to creditors and their collection for effective management of credit and its collection. 3. Credit Collection and Protection:Factor also helps in timely collection of debts. He also provides full or partial safeguard against bad debts. A factor also develops strategies to reduce the possibility of bad debts as much as possible. 4. Sales Leisure Management: It involves management of sales and leisure of client. Monthly statements have to be sent to client by customers. This service is provided by factor. 5. Other Services: In developed countries, a factor also provides a number of other services: (a) he gives information about prospective buyer; (b) he consults and assists his clients to effectively manage liquidity; (c) he finances the purchase of inventories; and (d) he also facilitates opening up of letter of credit by client, etc.

5 7. Types of Factoring There are mainly two types of factoring arrangements: Domestic Factoring and International Factoring. 1. Domestic Factoring: In case the parties are in the same country, it is domestic factoring. There are many domestic factoring arrangements: i) Full Service Non Recourse Factoring: In this case, complete risk of bad debts is borne by the factor. Client gets 80-90% amount of debt at the time of selling debts and remaining afterwards. Factor maintains all accounts of customers who have to pay directly to factor. It is also called Old-Line Factoring. It is suitable in following cases: (a) The amount of debt factored is very high. (b) A large number of customers have to be managed by the client. (c) The client wants to get 100% of the amount of debt. ii) Full Service Recourse Factoring: This kind of factoring provides only debt financing but not protection. That is the risk of bad debts is borne by the client. In case of bad debts, the factor can go back to the client and recover his loss. Thus, this is more risky for the client and thus the fee paid by him is comparatively lesser. It is suitable when the debt per customer is low and number of customers to be managed is less or the customers are not credit worthy. iii) Advance Factoring and Maturity Factoring: Recourse and non-recourse factoring can again be classified as Advance and Maturity factoring. In case of advance factoring, finance is granted to the client when the debts are sold whereas in case of maturity factoring, financing is done when the credit is matured. In maturity factoring, factor only performs function of collection. iv) Bulk/Agency Factoring: In this case, factor only performs the function of financing. That is he only grants finance against book debts. All other functions of assessing credit worthiness, maintaining accounts, credit management is done by client himself. It can be with recourse or non-recourse. v) Undisclosed/Non-Notification Factoring: In this case, factor performs all the functions without bringing it to the knowledge of customers. Factor operates in the name of a sales company through which customers deal with him. Thus, customers feel that they are dealing with the seller not a factor. This type is available in UK to financially strong companies. Opposite to this is disclosed (notified) factoring, where customers have the knowledge of working of factor. vi) Limited Factoring: In this case, the factor purchases a limited invoice of the selected customers rather than entire amount. vii) Buyer (Customer) Based Factoring: In this case, the factoring agreement is initiated by the customer rather than client. The customer contacts the factor for converting his

6 credit purchase into cash purchase. The customer ensures the factor for future payment. Apart from above, there are many other factoring arrangements between factors and clients. 2. International Factoring: When factoring arrangement is within exporters or importers, it is called export or international factoring. In this type, client is exporter, customer is importer and factor may be: (a) Export factor i.e. factor from exporter s country, and (b) Import factor i.e. factor from importer s country. i) Two Factor System: In this case, two factors (an import factor and an export factor) simultaneously perform factoring services. The contract is entered by the client with export and import factors. Export factor transfers all information to the import factor. Import factor provide all credit related information about the customer. Export factor helps in financing and import factor helps in collection and sends the amount back to export factor. The factor fee is shared by both and the loss of bad debts is generally shared by import factor but it is not a hard rule. It is the most common and effective factor arrangement. ii) iii) iv) Single Factor System: In this case, client makes the contract only with the export factor that enters into a separate contract with the import factor only in case of default. All the functions are performed by the export factor only. Customers also make payment to the export factor. In case of default, import factor transfers all necessary information to export factor. Credit risk is borne by export factor. Import factor only works as a sub-agent of export factor. Direct Export Factor:In this case, agreement is made only between exporter and export factor and no other party is involved. All the functions are performed by the export factor himself. Direct Import Factor: In this case, agreement is made only between importer and import factor and no other party is involved. All the functions are performed by the import factor himself. 8. Benefits and Costs of Factoring Factoring provides following advantages to a company: 1) It helps in elimination of trade discount. 2) It provides immediate finance and credit. 3) It helps to remove the cost of credit administration as the factors have specialization in that. 4) It increases the overall return to the client as cash may be used for many productive purposes. 5) It improves the liquidity position of the company and thus the working capital requirement is used. 6) It also provides the company protection against bad debts.

7 7) It provides useful information about markets, customers, etc. 8) Effective credit collection services of factor also help in improving credit worthiness of customers, thus reducing credit risk. 8.1 Costs of Factoring There are two types of costs associated with factoring i.e. monetary and non-monetary costs. 1) Monetary Costs: Factoring Commission: Client has to pay a commission to the factor for the services rendered by him. Interest Payment: It is made on the amount received as finance for the specified period of time. 2) Non-Monetary Costs: As the company employs a factor for managing debts, it reflects poor management by the company which negatively affects goodwill. If the customers are spread over a very large area, factoring may not serve the purpose. Thus, before getting engaged in a factoring arrangement proper analysis of monetary benefits and costs should be made to assess whether factoring is beneficial or not. Debts should be factored only if net benefits are positive. 9. Suitability of Factoring Factoring is not advisable in the following situations: a) Where sales are made for cash; b) In case of speculative business; c) For highly specialized capital equipments or goods made to order; d) If the credit period is more than 180 days; e) In case of consignment sale; f) Sales to associated companies; g) Sales are made to public at large. 10. Factoring vs. Bills Discounting Factoring and bills discounting, both are ways of short-term financing. However, factoring is different from bills discounting in the following ways: 1) Bill discounting only involves financing against bills but factoring involves financing, collection and protection against debts. 2) Bill discounting is always with recourse where risk of default is borne by the client whereas, factoring may be with recourse or without recourse.

8 3) Bill discounting is preferable only in case of lesser number of buyers whereas, factoring helps to manage a large number of buyers. 4) Bill discounting is preferable when the debtors are creditworthy whereas, factoring can be taken up in case of risky debtors as protection is also provided by factor. 11. Factoring vs. Short-Term Financing Factoring is different from short-term financing in the following ways: 1) Factoring is not only financing but also involves collection and protection of debts whereas, short-term financing is related to financing activities only. 2) In financing the book debts are sold to the factor for finance whereas no sale takes place in case of formal financing. 3) Factoring is much flexible as the client can take finance as and when required i.e. immediately or at maturity. Such option is not available in case of short-term financing. 4) Factoring provides a financial as well as a management function whereas, financing is a purely financial function where management of debtors done by the company itself. 5) Factoring charge involves service charge and interest payment whereas, in case of shortterm financing only interest payment is done by the company. 12. Practical Problems on Factoring Illustration 1 A Ltd. has total sales of Rs 3.6 crores and its average collection period is 90 days. The past experience indicates that bad debt losses are 2% on sales. The expenditure incurred by the firm in administering its receivable collection efforts are Rs 5,50,000. A factor is prepared to buy the firms receivables by charging 2% commission. The factor will pay advance on receivables to the firm at an interest rate of 18% p.a. after withholding 10% as reserve. Calculate the effective cost of factoring to the firm. Solution: Average level of Receivables (3,60,00,000 90/360) 90,00,000 Factoring commission (90,00,000 2/100) 1,80,000 Factoring reserve (90,00,000 10/100) 9,00,000 Amount available for advance (90,00,000-1,80,000-9,00,000) 79,20,000 Factor will deduct his Interest = 79,20, ,56, So, advance to be paid = Rs 79,20,000 Rs 3,56,400 = Rs 75,63,600 Cost of Factoring

9 Commission 1,80,000 Interest 3,56,400 5,36,400 Annualized cost = 5,36, = 21,45, Less: cost of credit administration saved 5,50,000 Less: cost of bad debts avoided 7,20,000 Net cost of factoring to the firm 8,75,600 Effective rate of interest to the firm = 8,75, % 75,63,600 Note: The number of days in a year has been assumed to be 360 days. Illustration 2 The annual sales of XYZ Ltd. is Rs 60 lakhs of which 80% is on credit. A month is allowed to debtors to clear off their dues. A factor is willing to advance 90% of the bills raised on credit for a fee of 2% a month plus a commission of 4% on the total amount of debts. XYZ Ltd. as a result of this arrangement is likely to save Rs 21,600 annually in management costs and avoid bad on the credit sales. A scheduled bank has come forward to make an advance equal to 90% of the debts at an interest rate of 18% p.a. However, its processing fee will be at 2% on the debts. Would you accept factoring or the offer from the bank? Solution: Factoring arrangement Cost of factoring: Fee of 2% on 90% of Rs 4,00,000 7,200 (80% of Rs 60 lakhs = 48 lakhs/12 = Rs 4,00,000 is the monthly credit sales) Commission at 4% on Rs 4,00,000 16,000 23,200 Less: Savings in cost Management cost (21,600/12) 1,800 1% savings of bad debts on Rs 4,00,000 4,000 Net cost of factoring 17,400 Bank advance Cost of bank advance: Interest 4,00, , Processing fee (4,00,000 2/100) 8,000 Bad debts loss (4,00,000 1/100) 4,000 Net cost of bank advance 17,400 Since costs of both alternatives are equal, it is immaterial whether XYZ Ltd. goes in for factoring or bank advance.

10 13. Summary Factoring is the financing given to trading and manufacturing firms by purchasing trade debts and helping in their collection. Three parties are involved in factoring arrangements client, factor and customer. Factor collects debts and also advances cash against debts to solve the liquidity problems of the client. For providing their services, they charges interest on advance and commission for other services. Factoring has three different aspects financial, management and legal aspect. There are mainly two types of factoring arrangements: Domestic Factoring and International Factoring. There is a difference between factoring and short-term financing because factoring is not only related to financing activities but also involves collection and protection of debts.

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