THE CONCEPTUAL FRAMEWORK OF FACTORING ON SMALL AND MEDIUM ENTERPRISES

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1 THE CONCEPTUAL FRAMEWORK OF FACTORING ON SMALL AND MEDIUM ENTERPRISES Minaxi Rani Assistant Professor (Extn.), Department of Commerce, Govt. College for women P.G. College, Hisar, Haryana, (India) ABSTRACT Today the size of the Business is very large. Business cannot sell all the goods and services in cash. Goods and services are sold cash as well as on Credit basis. Those to whom goods are sold on credit are the debtors, accounts receivable of the business. For collecting the amount from receivable business uses the services of factors. As well all know that the factoring is like blood in business that help the SME s to setup and to increase their operations, develop new product and services etc. There are so many source of financing for SME s such as internal and external. For the inefficiency of the internal sources there is the need of external source of finance. External load of finance include:- Loan from bank, overdraft facility, venture capital financing, asset taken on leasing, factoring etc. Factoring is an external financial tool, which allows the business to get money immediately after the sale of goods on credit, business doesn t wait till due date. Factoring helps the high risk suppliers to transfer their risk. This paper explain the conceptual framework of factoring, banks of factors, advantages and disadvantages of factoring, effect of factoring on SME etc. Keywords: SMC, Factoring, Financial, Intermediate, Advantaging, Disadvantaging, Factoring Procedure I. INTRODUCTION As we know that finance is life blood of the business. Business cannot grow without finance. Small business enterprises face many challenges to access the financing. Business sales goods after production on credit basis to the customers and customers normally want credit on a period of 30 to 90 days. During that time business wants further finance for production of goods and services. For this period the seller issue an invoice that is trade payable for the buyer and trade receivables for the seller. That is current liability for the buyer and current asset means illiquid asset for the seller. For taking the finance facility immediately business takes the services of the factor. Factor is the institution which provides services of collection and that process is known as factoring. Factoring is a financial tool process. In that process business sells its accounts receivables to the factoring supplier who give advance cash to the business. In that firms sell their credit-worthy accounts receivable at a concession rate such as discount that is generally equal to interest plus service fees that is charged by the supplier of the cash who supply prompt payment. Interest is charged for the time period for which the account receivables or invoices due or maturity date. Factoring is not provide cash as a loan they only provide immediate cash so that, that not create additional liabilities on the balance sheet of the firm. Factoring only provide the 253 P a g e

2 working capital financing. Factoring is an external financial service that includes accounts receivable, credit protection, maintenance of bookkeeping, collection from trade receivables and financing the business. In factoring the credit invoices are sold to a third party, that third party is known as factoring company and that company provides prompt payment against such invoices. The payment procedure of the factoring company is that company pays the amount of the invoices in two installments. The amount of the first installment is around 60 to 90 % of the amount of the invoice and that amount is directly posted in to the bank account with in one or two days. The second installment is paid by the factoring company to the supplier of the receivables after the payment is received from the customer. The amount of the second installment is balance amount of the receivables minus factoring company s fee and interest if any charge by the company. The fee of the factory is depending upon the company to company. Normally that fee is 1.5 to 5% of the factor value. That fee is also depending upon the customers credit rating, time period of the invoice and services that is provided by the factoring company. The factoring services is beneficially to those business unit who sells goods mainly on credit basis and factors provide them cash flow that money flow help them to payments of staff salaries, payments to suppliers, purchase goods in large quantities and also free to the collection staff from the collection work which can modify to some other department. It is a win-win situations for the companies who use the services of the factor because by the use of the factoring services business do not need to take the loan from the bank for financing the business activity which previously depend upon the bank and for taking the loan a business need to fulfill the various guarantees and documents and that is a very long process. Business money is not locked on the receivable which previously locked on the receivable. Business can also purchase goods on large quantity when received cash from the factors and take the advantage of discount also. It should also remind that factoring services is not giving advantage to all the companies. It is beneficially for those companies who have a minimum of 15% margin on sales and credit period offered to them is not so long. 1.1 Salient Features of Factoring (i) Coverage of Credit The factoring services take the risk and uncertainty of the client and advances is covered by the client through factor. (i) Advantage of Cash Factors provide the advatange of cash to the client after receiving the documents such as receivables, Invoices etc within one day. (ii) Preparation of Sales Ledger Factoring companies also provide the facility of preparations of computerized sales ledger and stored all the data by date and time. (iii) Collections from Debtors In that process factor buys the receivables from the client and then collect the amount of receivables, Cheques, invoices from the creditors on the due date or before and after as the case may be. (iv) Provide Valuable Advice The factoring companies provide very valuable advices to the client company such as information about customer credit worthiness, information about supplier, information about insolvent persons etc. 254 P a g e

3 (ii) Glossary of Terminology There are some common terms that are used in factoring process. These are as follows:- 1. Client client is the business institutions who supplied goods on credit basis to the customers and take the advantages of the factoring services. 2. Customer Here is the customer is the those person or organization to whom the goods and services are sold on credit basis. They are the debtors or receivables of the company. 3. Debtors reveivables and account receivables When the goods and services are sold on the credit basis trade reveivables are arrised. 4. Debt must be eligible fators which takes the debt must be eligible. 5. Retention moneny When a company takes the advantage of the factor services that company must add the maintained by the company. 6. Advance Payment Factors also gives the benefit of working capital requirement. They give the advantage of prepayment of the receivables. II. TYPES OF FACTORING The types of factoring are discussed below: (i) Recourse Factoring (ii) Non-Recourse Factoring (iii) Advance Factoring (iv) Disclosed Factoring (v) Undisclosed Factoring. (vi) Full factoring or conventional type of factoring (vii) Limited factoring (viii) Domestic factoring and export factoring (i) Recourse:-In recourse type the final risk of the Bad-debts is on the seller company who sells goods on credit to the client. In that factors assumes that there is no credit risk linked with the receivables and if there is Bad-debts that is borne by the client. So that we can say that type of factor work like only on an agent of the client companies receivables. Factors takes their service charge from the client company such as fees, interest, management of the receivables of the company and debt collection. (ii) Non-Recourse:-That is reverse of the recourse. In that type of the factoring the final risk of the Bad-debts is on the factor company who takes the client receivables. In that factors assumes that there is credit risk associated with the account receivables and so that bad debts is borne by the factors. In that factor bears the risk of bad-debts so that fees changed recourses. They take additional commission such as Deal cruder commission for bearing the bad debts so that the cost of that type of factor service is more than the recourse type. (iii) Advance factoring: as the name clear in that the factor provide some cash advantage after taking the receivables of the client. In that factor provide some cash such as 75-90% of the Value of the receivable to the client. And balance amount is provided after taking the payment from receivable. So that we can say that payment is provided in to two installment. First installment is as above and the amount of the 255 P a g e

4 second installment is provided after receiving from client after deduction from that amount interest, commission and discount is depend receivables. In that type sometimes bonus also take participation. Example: Total amount of Trade Receivables 1000 A factor finance the 80% of the Dept 800 Balance value of debts 200 Bank finance the 50% of finance 100 So the factor and the bank together pays to the client 90% of the trade receivables and client s now share in investment is only 10% of the total amount of receivables. From that balance factor take their commission, interest, discount, fees etc. (iv) Disclosed factoring: In disclosed type of the factoring, the seller company disclose the factor name on the invoice or receivables. Buyer also notifies that on the due date buyer has to pay to the factoring company not to the seller company. Here the buyer knows about the factor. Disclosed factoring may be the type of recourse and non recourse as the case may be. (v) Undisclosed factoring: In undisclosed type of the factoring, the seller company do not disclose the name of the factor on the invoices or receivables. Buyers does not nothing about the factors. (vi) Full factoring or conventional type of factoring: as the name suggest the full factoring, --- provide full services such as preparations of the sales ledger, credit collection from the debtors, control over the credit and provide credit insurance facility. In that factors also give advice and suggestion to whom not. Because they know the credit worthiness of the customers. It is also known as old live factoring. (vii) Limited factoring: that is reverse of the full factoring. In that type the seller takes only the selected trade receivable and discounts only that selected trade receivable and that also convert the credit bills into cash. (viii) Domestic factoring and export factoring: There is difference between domestic factoring and export factoring. The no of the parties involved in that type is three. a. Customers b. Clients (sellers) c. Factor(Financial intermediates) All the three parties are from the some country in the domestics factoring. Export factoring is also known as the cross border factories or international factoring and that is similar to the domestic factoring. But in that type of factoring parties are involved. 1. The exporter (Clients) 2. Importer (Customer) 3. Export factor 4. Import factor That type of system is also know as two factor system of factoring. In that two separate but inter-linked contracts. 256 P a g e

5 III. FACTORING PROCEDURE There are various steps involved in the factoring process Step I. Firstly the customer places an order with the seller or to whom we also called them client also when takes the advantage of the factors. Step II. After receiving the order the goods are delivered to the buyer and the invoice is also send along with the notice to pay to the factor. Step III. Then the factoring company and the selling company also entered into the various agreements about the various terms and conditions. Step IV. The copy of invoice covering the above sale is sent to the factors, who maintain the sales ledger. Step V. The factor pays some amount as an advance such as the 80% of the amount of the receivables. Step VI. Monthly Account Statements, Ledgers are also sent by the factor to the buyer. Step VII. Actions are taken intimately for the outstanding receivables Step VIII. The buyer of the goods paid the amount of the trade receivables on the due dates. Step IX. After all the procedure the 2 nd installment is paid by the factor to the client from the balance of 20% less the cost of factoring is paid by the factor to the client. IV. ADVANTAGE OF FACTORING 1. Factoring helps the client company to improve their current ratio. If current ratio is improved then the liquidity of the company is also improved. That improved current ratio helps in the working capital position also. 2. When the advances is provided by the factoring company it also helps in increase the turnover because the goods are sold on credit. 3. Reduce the risk of Bad debts. 4. It also helps in the quick payment to the client. 5. Reduce the overburden of the collection staff. 6. The responsibility of the business is also reduce. V. LIMITATIONS OF FACTORING 1. That type of the financing process is not suitable for the companies whom turnover is very less. 2. By the use of the factoring services business is over dependent upon the factor and self efforts are very less. 3. Developing companies does not take full advantage of the factoring because lack of professionalism in comparison to the developed countries. 4. Factors are not fully expertise in their services so that that method is not suitable for the companies who are selling highly specialized product. 257 P a g e

6 VI. SUGGESTIONS Developing countries also takes advantage of the factoring. In the factoring all the parties must be honest, dutiful and professional. They have full knowledge about the credit worthiness of the customer, terms of credit and the period of the credit. VII. CONCLUSIONS In conclusions we can say that the factors are external source of financing and by the use of the factors efficectively business can reduce the risk of the bad debts. Working capital of the business is also improved through the advances provided by the factor to the client. Business also purchased goods on bulk quantity, payment of staff salary, maintenance of liquidity etc through the cash provided by the factor. REFERENCES [1.] The Role of Factoring for Financing Small and Medium Enterprises World Bank Policy Research Working Paper Leora F. Klapper [2.] In return to the factoring Information, EFA 2004 Maastricht meetings Paper No [3.] The Role of Credit Rating Agencies in the Establishment of Capital Standards for Financial Institutions in a Global Economy, Howell E. Jackson [4.] Muschella, D., The Italian factoring industry. Mimeo Bakker, M.-R., Klapper, L., Udell, G., [5.] The role of factoring in commercial finance and the case of Eastern Europe, World Bank working paper. 258 P a g e