Factoring. To explain nature, function and types of factoring. To dilate upon modus operandi of factoring.

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1 Learning Objectives: Factoring To explain nature, function and types of factoring. To dilate upon modus operandi of factoring. To bring out potentiality of factoring as a source of finance. To highlight the need for factoring in India. To Evaluate recent developments regarding factoring in India. Chapter 10 Factoring Financial Management II 1

2 Factoring Structure : Backdrop. Concept of factoring. Functions of factor. Types of factoring. Modus Operandi of a factor. Potentiality of factoring as a source of short term finance. Emergence of factoring abroad. Factoring in India. Chapter 10 Factoring Financial Management II 2

3 Backdrop With growing industrialization and consequential growth in the volume of production and sales, timely collection and efficient management of receivables has assumed importance in the buyer s markets today. Demand of credit terms on one s purchases and granting them on sales are universal. But quantum of sales is always greater than that of purchases, thus larger amounts of credit are always given. If their collection is delayed it has adverse impact on firm s liquidity. Commercial banks do provide finance against receivables, but it is with recourse to supplier. If within stipulated period debtor does not pay, bank calls upon supplier / borrower to repay the finance. Chapter 10 Factoring Financial Management II 3

4 Backdrop Inability to collect receivables on time, thus strains the working capital. In the environment of fierce competition, nor are firms in a position to collect interest on overdue payments from their customers. Banks do provide collection services in case of bills purchased/discounted by them, but do not undertake collection of debts from customers. The issue is further complicated by the fact that, firms do not possess accurate data on reliability and creditworthiness of their, especially far off, customers. Factoring as a source of business finance is, therefore, becoming popular the world over. Chapter 10 Factoring Financial Management II 4

5 Concept of Factoring Factoring, also called invoice discounting is a method - by which a businessman obtains cash for invoices to his customers - from a Factor, which can be a financial company or a bank. - if customer does not pay, factor bears the loss, as factoring is normally without recourse to seller. - - The client does not carry factored receivables in his balance sheet. - usually Factor selects receivables he wants to purchase from seller s total receivables. - seller can trade with balance, but responsibility for collection stays with him. Chapter 10 Factoring Financial Management II 5

6 Concept of Factoring Factoring involves rendering of services varying from bill discounting facilities offered by banks to total takeover of 1] administration of the sales ledger, 2] credit control functions, 3] credit approval, 4] collecting cash, 5] credit insurance and 6] provision of finance. Factoring agreement is usually continuous, as new receivables arise, they get regularly sold to the factor. Customers are notified that the account has been sold to the factor and payments are to be arranged to him. Factor allows client to overdraw the account on occasions and charges interest & also pays interest on the funds left with him. Chapter 10 Factoring Financial Management II 6

7 Functions of a Factor Maintenance of Sales Ledger: Client just sends a copy of invoice to Factor. Monitoring payments, maintaining ledgers, creating reports and providing data to client are carried by Factor. Collection of Accounts Receivables: Follow up measures for collection are effectively undertaken by Factor using his infrastructural facilities and expertise. Client can focus on his core business activity. Chapter 10 Factoring Financial Management II 7

8 Functions of a Factor Credit Control & Credit Protection: Based on data collected on timeliness of payments, volumes for each customer, Factor provides specialized service to client on the extent of credit that client can effectively provide its customers. Client can update his credit policy and handle higher volumes with confidence. Advisory Functions: As a credit specialist, based on comprehensive studies of economic conditions, Factor can advise client regarding impending developments & trends in client s industry. Additional technical inputs on work load analysis, machinery replacement programmes, etc are also given. Chapter 10 Factoring Financial Management II 8

9 Types of Factoring Different services are provided by Factors to meet clients varied requirements. On the basis of the nature of services offered, factoring can be categorized as Full Factoring Recourse Factoring Maturity Factoring Advance Factoring Undisclosed Factoring Invoice Discounting Buyer-based Factoring Seller based Factoring Chapter 10 Factoring Financial Management II 9

10 Types of Factoring Full Factoring Here Factor renders services of collection, maintains sales ledgers, credit control & credit protection. He sets limits for each client up to which factor collects without recourse to client. In case payment is withheld on account disputes related to quality, quantity etc Factor has recourse to client. Recourse Factoring Here client has no protection in case of non-payment by customers as factoring is with recourse to the seller. Chapter 10 Factoring Financial Management II 10

11 Types of Factoring Maturity Factoring Here there is no financing by Factor ab initio. Factor maintains client s sales ledgers and arranges debt collection. The payments against each invoice is arranged by Factor at end of credit period or at agreed maturity date. Such factoring can be with or without recourse. Advance Factoring In this kind of factoring, Factor is prepared to pay debts in advance of receiving the payment due from customers. This is only pre-payment not an advance. A drawing limit is made available to the client as soon as invoice is accounted for. Chapter 10 Factoring Financial Management II 11

12 Types of Factoring Undisclosed Factoring Unlike all other types, in undisclosed factoring customers are not notified about the arrangement between the Factor & the client. The factor maintains sales ledger for the client and provides either debt default cover or finance or both if so desired. A check on the risk is maintained using age wise analysis of debtors. Invoice Discounting Her Factor does not maintain sale ledgers nor does he arrange debt collection. Factor simply discounts all or selected invoices and provides finance to client. Chapter 10 Factoring Financial Management II 12

13 Types of Factoring Buyer-based Factoring Under this arrangement Factor prepares a list of approved buyers and factors all the payable of such buyers. Any claims on the buyers are factored without recourse to sellers Seller based Factoring The factor, in this case, takes over entire credit function of the client. He asks for a copy of the invoice along with the delivery challan, the buy-sell contract, quality test certificates etc and undertakes the reminding functions of follow ups, maintenance of ledgers and debt collection. All required data for sales analysis by areas, sales persons, products, defaults, taxes, excise etc is furnished by Factor. Chapter 10 Factoring Financial Management II 13

14 Modus operandi of a Factor Where a firm has decided to factor its receivables, it provides a list of customers, amount of order, terms of sale etc prior to despatch of materials. Factor accepts or rejects the invoice after checking client account. If client supplies materials against reject decision liability for collection rests with the client. After goods are despatched, client prepares an assignment schedule which along with invoices is provided to factor, and buyers are notified to make payment to Factor. Chapter 10 Factoring Financial Management II 14

15 Modus operandi of a Factor Factor scrutinizes the assignment and the client s account is credited with the entire amount less commission in case of approved buyers and 90% of invoice value less commission in case of unapproved buyers. Monthly account is provided by the Factor to the client. It provides - full records about commission and interest charges and - details revealing financial standing the client has with him. Chapter 10 Factoring Financial Management II 15

16 Potentiality of Factoring as a Source of Short Financing Factoring is becoming popular all over the world as volume of business is growing factor performs the function of buying debts without recourse to client. support is provided to meet working capital needs. client is freed from botheration of collecting receivables. nor is he required to maintain credit department. Factor provides credit planning and control guidelines on the basis of data on clients customer base. Chapter 10 Factoring Financial Management II 16

17 Potentiality of Factoring as a Source of Short Financing However, the most critical fallout of Factoring is institutionalization and perpetuation of credit and delayed payments. Tough stance taken by Factor can result in cancellation of further orders from the concerned customer. In spite of these drawbacks, for small and medium scale enterprises, reduction in inventory and accelerating velocity of receivables are assuming paramount importance and factoring provides required solutions in these conditions. Chapter 10 Factoring Financial Management II 17

18 Emergence of Factoring Abroad Modern factoring service started in the USA in 1920s. It did not spread abroad until 1960s. There after it grew dramatically. Over 700 companies are operating in forty countries. These companies are owned by well known banks or financial institutes. Factoring services of late have taken roots in developing countries. In Indonesia, Mexico or Thailand they have exceeded all expectations. Same holds good for Europe, latest to join the factoring band wagon is China Chapter 10 Factoring Financial Management II 18

19 Factoring in India The first factoring company in India was set up by Canara Bank & RCF in recognition of the utility of factoring service to small scale units to solve their working capital needs, to collect and cover their receivables and to provide technical assistance especially in marketing. In 1988 RBI appointed a study group to examine the feasibility and mechanics of factoring in India and recommending for their constitution, organizational set up, scope of activities and other related matters. The group recognized the need for such service, but cautioned that factoring per se cannot solve the problems of delays and defaults in payments. Chapter 10 Factoring Financial Management II 19

20 Factoring in India Based on the study group s recommendations Banking Regulation Act was amended in 1990 and RBI directed that factoring activities could be started by the banks through the specialized subsidiaries. State Bank & Canara Bank set up companies to provide factoring service. The market potential was determined at Rs. 4,000 crores. To provide impetus to factoring RBI provided an option to banks to undertake the activity departmentally. The RBI directed that : 1] Factoring activities be treated on par with loans and advances and should accordingly be given risk weight of 100% for calculation of capital to risk asset ratio. The guidelines on asset classification, income recognition and provisioning are applicable to them. Chapter 10 Factoring Financial Management II 20

21 Factoring in India 2] A bank s exposure shall not exceed 25% of the bank s capital funds to a single borrower and 50% to a group of borrowers. 3] Factoring services should be extended only to those invoices which represent genuine trade transactions. Third factoring subsidiary was set up by UCO, UBI and Allahabad Banks to cater to the Eastern zone. Small Industries Development Bank of India has also introduced its own factoring service in ECGC also evolved a non-fund based export factoring service for exporters only. Chapter 10 Factoring Financial Management II 21

22 Factoring in India As regards exposure norms of banks to factoring services, RBI has advised that banks should maintain a balanced portfolio of factoring services vis-s-vis the aggregate credit. Their exposure to this activity should not exceed 10% of total advances. The End! Next chapter 11 Good Luck! Trade Credit Chapter 10 Factoring Financial Management II 22

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