Factoring Services WHAT IS FACTORING? MECHANICS OF FACTORING

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1 Factoring Services S Balasubramanian, Vice President (Finance) & Company Secretary, Canbank Factors Ltd., Bangalore. Realisation of outstanding dues is increasingly becoming a complicated and tedious exercise. Factoring seeks to address this problem by helping creditors to realize their dues. This article explains the mechanics of factoring services. Most of the manufacturers and suppliers of goods and services experience lot of difficulties in collecting their book debts in time. Delays in collection often lead to liquidity problems, delayed production and supply, affecting the growth of industry. Cash provides the necessary lubrication for the wheels of business and industry to move smoothly. These days, where most of the sales is on credit, none can be sure of prompt payments. Irregular realization may result in inadequate cash flow and all consequential problems. One of the ways to ensure smooth cash flow is to avail "Factoring Services." WHAT IS FACTORING? Factoring is a new financial service which was introduced during 1991 in India. It is, in fact, not just a single service, but a portfolio of complementary financial services. Factoring is a powerful alternative instrument, particularly designed to meet the post sales working capital requirement of the Industrial/Trade/Service Sector. Clients (i.e., Sellers) can avail themselves of some or all of these, according to their individual needs. The Functions of a Factor are : - Sales ledger administration. Debt collection services. Finance generally up to 80% of the Invoice value and in exceptional cases up to 100% of the invoice value. Credit Insurance Advisory Services. MECHANICS OF FACTORING 1. Customer places order on the client. 2. Factor fixes customer limit. 3. Client delivers goods and invoice to customer with notice to pay Factor. 4. Client tenders copy of invoice to Factor. 5. Factor makes prepayment up to 80% of the invoice value. 6. Factors sends monthly statements to customers. 7. Factor follows up if unpaid by due date. 8. Customers makes payment to Factor.

2 9. Factor releases balance amount to the client. Methodology Clients enter into a factoring arrangement with the factor, who takes responsibility for dealing with all their receivables. Factor fixes a limit for purchase of debts and allows prepayment generally up to 80% of the invoice value. The original invoice and title documents (like LRs or RRs) can be directly sent by clients to their customers (i.e., buyers), and only copies handed over to the factor. Depending upon the individual customer limits fixed by the factor, the invoices are purchased and prepayments made. The invoice carries a clause of "assignment of debt" in favour of the factor and directs the customer to pay the factor direct. The factor now follows-up with the customer for payment. In recourse factoring, ultimate customer risk is borne by the clients, and in full factoring, by the factor. FACTOR-YOUR WORKING CAPITAL PARTNER Commercial banks normally provide working capital finance to the trade and industry, this takes the form of cash credit facility against inventory and bills finance against receivables. For a variety of reasons (eg., buyers not willing to accept the bills of exchange, or delays involved in routing documents through banks). Suppliers are unable to avail bills finance, and in such cases, factoring could be a very practical alternative. Factors normally handle receivables of the client on the whole turnover principle. However, if it is possible to bifurcate sales into, bills based and open account sales, limit for the former could be retained in the bank and the latter may be tendered for factoring. If the client has charged his receivables as security for cash credit facility provided by the bank, a letter of disclaimer from the Bank would obviously be needed. Arrangement between the Bank and the Factor includes routing of all payments made by the Factor through Client s operative account with Bank. It is as though hypothecated finished goods have become cash! Thus, in a Factoring arrangement, all that happens is, the client shares the post-sale component of the working capital with the Factor, who specializes in handling receivables. Benefits of Factoring In Factoring the buyer need not accept a Bill of Exchange. He has to just abide by the notice on the invoice by the seller, to pay the value of invoice directly to the Factor. The benefits of Factoring vis-a-vis Bank Finance are as under : SL. NO. AREA FACTORS BANK 1 Funding Up to 80% Normally % 2 Availability of Finance Instant against each invoice akin to cash sales Periodically (Monthly/Fortnightly). No DP for intermediate invoices.

3 3 Collection In-Built Not done 4 Collection Time Very Fast (Through the Branches) Takes time (Collection of Cheques) 5 Credit Period Market related and flexible approach up to 1 Days Generally uniform - 60 to 90 days only. 6 Customer Evaluation Customers evaluated and sublimits fixed (Indirect Credit) Protection No such service 7 Follow-up of Closely followed up No such service 8 Based Services Sales Ledger Administration, MIS Data furnished (Age-wise breakup, Overdues statement, etc..) No such services. Financing alone done. 9 Bifurcation of Limits No Bifurcation like CC account Higher limits are bifurcated to CC and Demand Loan. 10 Submission of Returns Stock/ statements, select monthly operational data, Financial follow up report need not be submitted. Financial Follow-up Reports, etc. Should be submitted. 11 Computerization Total Partial (Depends on Branch) 12 of Associates Selectively Factored Not financed Accounting The debts of the company which are assigned in favour of the factor can be removed from current assets and the margin retained by the factor alone needs to be shown under "Other Current Assets." However, the prepayment amount received from the Factor has to be shown under "Contingent Liabilities", as Factor retains the right of recourse "to the client" in case of non-payment by the customer. The above method of presentation helps in improving the overall working capital position of the Company and thereby increases the Current Ratio. To illustrate this point we present below two situations : Before availing Factoring Services

4 (Amount in Rs.) Liabilities Assets Shareholders funds 85 Fixed Assets Current Liabilities : Current Assets : Bank Overdraft 90 Inventory Sundry Creditors Other Current Liabilities Other Current Assets 25 Total Liabilities 225 Total Assets 225 CURRENT RATIO : 1.25 After availing Factoring Services : - Factoring Pre-payment Limit : Rs.100 Margin : % Prepayment availed : Rs. 80 Liabilities Assets Shareholders funds Current Liabilities : Bank Overdraft Sundry Creditors Other Current Liabilities Fixed Assets Current Assets : Inventory Other Current Assets Due from factors Nil 25 Total Assets 145 CURRENT RATIO : 1.58 Contingent Liabilities

5 Pre-payment received towards Bills factored with M/s Canbank Factors Ltd., pending Realisation àrs.80 From the above it may be observed that the factoring arrangement not only helps a client in improving his "cash flow position", but also enables him to show a better working capital position and thereby presents a better Balance Sheet at any given point of time. Cost of Services Unlike in Western countries, Factoring in India is quite inexpensive. Factor charges discount on the Prepayment drawn by the Client and the rates are on par with Bank s lending rates. Discount charges are collected monthly on actual drawings in the prepayment account. There is also a service charge, ranging from 0.1% to 0.5% of the invoice value, depending upon the services availed, and volume of transactions. FOOTNOTES: balu_subramanian@hotmail.com