AN OVERVIEW OF FACTORING SERVICES

Kushal Walia –

UM10905

Pujit Singh -

UM10304

Shivam Miglani -

UM10307

Sahib Singh –

UM10809

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TABLE OF CONTENTS

1 What is Factoring? ............................................................................................................ 2

1.1 Formal definition ........................................................................................................ 2

1.2 How does it actually work? ....................................................................................... 2

1.3 Characteristics ........................................................................................................... 3

2 Types of Factoring ............................................................................................................ 4

3 Procedural Aspects: ......................................................................................................... 5

3.1 The Factoring Process .............................................................................................. 5

3.2 Functions of the Factor ............................................................................................. 6

3.2.1 Administration of Sales Ledger ......................................................................... 6

3.2.2 Collection of Receivables ................................................................................... 6

3.2.3 Provision of Finance ........................................................................................... 7

3.2.4 Protection against Risk ...................................................................................... 7

3.2.5 Advisory Services ............................................................................................... 7

4 Importance of Factoring ................................................................................................... 8

4.1 Advantages of Factoring: .......................................................................................... 8

4.2 Limitations of Factoring: ........................................................................................... 8

5 Financial Aspects of Factoring ........................................................................................ 9

5.1 Factoring and the balance sheet .............................................................................. 9

5.2 Factoring And Profit And Loss Account .................................................................10

5.3 Treatment under GAAP ............................................................................................10

5.4 Factoring Charges ....................................................................................................10

6 Prospects of Factoring in India .......................................................................................11

6.1 GROWTH OF THE FACTORING INDUSTRY IN INDIA .............................................11

6.1.1 Need for Factoring Services in India ................................................................11

6.1.2 RBI Guidelines ...................................................................................................11

6.1.3 SBI Factors and Commercial Services .............................................................11

6.1.4 Canbank Factors Ltd. ........................................................................................11

6.2 Reasons for Slow Growth ........................................................................................12

6.3 Suggestions: .............................................................................................................12

7 References .......................................................................................................................13

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1 WHAT IS FACTORING?

One of the oldest forms of business financing, factoring is the cash-management tool of choice for many

companies. Factoring is very common in certain industries, such as the clothing industry, where long

receivables are part of the business cycle.

1.1 FORMAL DEFINITION

Factoring is a continuing arrangement between a financial intermediary known as

the factor and a business concern the client whereby the factor purchases the

client’s accounts receivable/book debts with or without recourse to the client

1.2 HOW DOES IT ACTUALLY WORK?

In a typical factoring arrangement, the client (you) makes a sale, delivers the product or service and

generates an invoice. The factor (the funding source) buys the right to collect on that invoice by

agreeing to pay you the invoice's face value less a discount--typically 2 to 6 percent. The factor pays 75

percent to 80 percent of the face value immediately and forwards the remainder (less the discount)

when your customer pays.

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1.3 CHARACTERISTICS Because factors extend credit not to their clients, but to their clients' customers, they are more

concerned about the customers' ability to pay than the client's financial status. That means a

company with credit-worthy customers may be able to factor even if it can't qualify for a loan.

Once used mostly by large corporations, factoring is becoming more widespread. Still, plenty of

misperceptions about factoring remain.

Factoring is not a loan; it does not create a liability on the balance sheet or encumber assets. It is the

sale of an asset--in this case, the invoice. And while factoring is considered one of the most expensive

forms of financing, that's not always true. Yes, when you compare the discount rate factors charge

against the interest rate banks charge, factoring costs more. But if you can't qualify for a loan, it doesn't

matter what the interest rate is. Factors also provide services, banks do not: They typically take over a

significant portion of the accounting work for their clients, help with credit checks, and generate

financial reports to let you know where you stand.

The idea that factoring is a last-ditch effort by companies about to go under is another

misperception. Walt Plant, regional manager with Altres Financial, a national factoring firm

based in Salt Lake City, says the opposite is true: "Most of the businesses we deal with are very

much in an upward cycle, going through extremely rapid growth." Plant says you may be a

candidate for factoring if your company regularly generates commercial invoices and you could

benefit from reducing the time receivables are outstanding. Factoring may provide the cash you

need to fund growth or to take advantage of early-payment discount suppliers offer.

Factoring is a short-term solution; most companies factor for two years or less. Plant says the factor's

role is to help clients make the transition to traditional financing. Factors are listed in the telephone

directory and often advertise in industry trade publications. Your banker may be able to refer you to a

factor. Shop around for someone who understands your industry, can customize a service package for

you, and has the financial resources you need.

Credit Cover: The factor takes over the risk burden of the client and thereby the client’s credit is

covered through advances.

Case advances: The factor makes cash advances to the client within 24 hours of receiving the

documents.

Sales ledgering: As many documents are exchanged, all details pertaining to the transaction are

automatically computerized and stored.

Collection Service: The factor, buys the receivables from the client, they become the factor’s debts and

the collection of cheques and other follow-up procedures are done by the factor in its own interest.

Provide Valuable advice: The factors also provide valuable advice on the country-wise and customer-

wise risks. This is because the factor is in a position to know the companies of its country better than

the exporter clients.

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2 TYPES OF FACTORING

The types of factoring are discussed below:

(i) Recourse Factoring: In Recourse factoring the credit risk remains with the client, though the debt is

assigned to the factor, i.e., the factor can have recourse to the client in the event of non-payment by the

customer.

(ii) Non-Recourse Factoring: The Non-Recourse Factoring also called as ‘Old-line factoring’. It is an

arrangement whereby he factor has no recourse to the client when the bill remains unpaid by the

customer. Thus, the risk of bad debt is absorbed by the factor.

(iii) Advance Factoring: Where the payment is made by the factor immediately is called Advance

Factoring Under this type of factoring, the factor provides a financial accommodation apart from non-

financial services rendered by him.

(iv) Confidential and Undisclosed Factoring: In confidential and undisclosed factoring the arrangement

between the factor and the client are left un-notified to the customers and the client collects the bills

from the customers without intimating them to the factoring arrangements.

(v) Maturity Factoring: In maturity factoring method, the factor may agree to pay an amount to the

client for the bills purchased by him either immediately or on maturity. The later refers to a date agreed

upon on which the factor pays the client.

(vi) Supplier Guarantee Factoring: Supplier Guarantee Factoring is also known as ‘drop shipment

factoring’. This happens when the client is a mediator between supplier and customer. When the client

is a distributor, the factor guarantees the supplier against the invoices raised by the supplier upon the

client and the goods may be delivered to the customer. The client thereafter raises bills on the customer

and assigns them to the factor. The factor thus enables the client to make a gross profit with no financial

involvement at all.

(vii) Bank Participation Factoring: In bank participation factoring the bank takes a floating charge on the

client’s equity, i.e. the amount payable by the factor to the client in respect of his receivables. On this

basis, the bank lends to the client and enables him to have double financing.

(ix) Cross-border/International Factoring: In domestic factoring, there are 3 parties involved – customer,

client and the factor. But in international factoring, 4 parties are involved, namely – exporter(client),

importer(customer), export factor, and import factor.

(x) Invoice Discounting: It is a variant of factoring, It provides finance against invoices backed by letters

of credit by banks. The factor provides finance once the letter of credit opening bank confirms the due

date of payment.

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3 PROCEDURAL ASPECTS:

3.1 THE FACTORING PROCESS The steps involved in factoring are discussed below:

In a typical factoring arrangement, the client (you) makes a sale, delivers the product or service and

generates an invoice. The factor (the funding source) buys the right to collect on that invoice by

agreeing to pay you the invoice's face value less a discount--typically 2 to 6 percent. The factor pays 75

percent to 80 percent of the face value immediately and forwards the remainder (less the discount)

when your customer pays.

The diagram depicts the 9-step process of factoring.

Factoring is divided into 9 discrete steps, each of which involve some financial considerations, which

have been discussed in the following sections.

Step I. The customer places an order with the seller (the

client).

Step II. The factor and the seller enter into a factoring

agreement about the various terms of factoring.

Step III. Sale contract is entered into with the buyer and the

goods are delivered. The invoice with the notice to pay the factor is sent along with.

Step IV. The copy of invoice covering the above sale is sent to the factors, who maintain

the sales ledger.

Step V. The factor prepays 80% of the invoice value.

Step VI. Monthly Statements are sent by the factor to the

buyer.

Step VII. If there are any unpaid invoices follow up action is

initiated.

Step VIII. The buyer settles the invoices on expiry of credit

period allowed.

Step IX. The balance 20% less the cost of factoring is paid by

the factor to the client.

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3.2 FUNCTIONS OF THE FACTOR The purchase of book debts or receivables is central to the function of factoring permitting the factor to

provide basic services such as:

3.2.1 Administration of Sales Ledger

The factor assumes the entire responsibility of administering sales ledger. The factor maintains sales

ledger in respect of each client. When the sales transaction takes place, an invoice is prepared in

duplicate by the client, one copy is given to the customer and the second copy is sent to the factor.

Entries are made in the ledger on open-item method. Each receipt is matched against the specific

invoice. On any given date, the customer account indicates the various open invoices outstanding.

Periodic reports are sent by factor to the client with respect to the current status of receivables and

amount received from customers. Depending upon the volume of transactions, the periodicity of the

report is decided. Thus, the entire sales ledger administration responsibility of the client gets transferred

to the factor. He performs the following functions with regard to the administration of the sales ledger:

i. He ensures that invoices raised represent genuine trade transactions in respect of goods

sold or services provided.

ii. He updates the sales ledger with latest invoices raised and cash received.

iii. He ensures that monthly statements are sent to the debtors, efforts are made to collect the

dues on the due dates through an efficient mechanism of personal contacts, issuance of

reminders, telephone messages etc.

iv. He remits the retention to the clients after collection of the dues. Where the factoring is

operating on Fixed Maturity Period (FMP) basis, the factor is to ensure that the client

receives the retention money at the expiry of the said period.

v. He establishes close links with the client and the customers to resolve the various disputes

raised in respect of quantity or quality of the goods/services supplied besides the

unauthorized discounts claimed or deducted by the debtors while making payment.

vi. He reviews the financial strength of the debtors at periodic intervals to ensure the

collectability of debts.

vii. He submits at periodic intervals the reports containing information as to the details of

overdue unpaid invoices, disputes, legal cases etc. to the client.

3.2.2 Collection of Receivables

The factor helps the client in adopting better credit control policy. The main functions of a factor is to

collect the receivables on behalf of the client and to relieve him from all the bother- actions/problems

associated with the collection. This way the client can concentrate on other major areas of his business

on one hand and reduce the cost of collection by way of savings in labour, time and efforts on the other

hand. The factor possesses trained and experienced personnel, sophisticated infrastructure and

improved technology that helps him to make timely demands on the debtors to make payments.

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3.2.3 Provision of Finance

Finance, which is the lifeblood of a business, is made available easily, by the factor, to the client. A factor

purchases the book debts of his client and debts are assigned in favour of the factor. 75% to 80 percent

of the assigned debt is given as an advance to the client by the factor.

a. Where an agreement is entered into between the client (seller) and the c factor for the purchase of

receivables without recourse, the factor becomes responsible to the seller on the due date of the

invoice whether or not the buyer makes the payment to the factor.

b. Where the debts are factored with recourse – the client has to refund the full finance amount

provided by the factor in case the buyer fails to make the payment on the due date.

3.2.4 Protection against Risk

This service is provided where the debts are factored without recourse. The factor fixes the credit limits

(i.e. the limit up to which the client can sell goods to customers) in respect of approved customers.

Within these limits the factor undertakes to purchase all trade debts and assumes risk of default in

payment by the customers. The factor not only relieves the client from the collection work, but also

advises the client on the credit worthiness of potential customers. Thus the factor helps the client in

adopting better credit control policy. The credit standing of the customer is assessed by the factors on

the basis of information collected from credit rating reports, bank reports, trade reference, financial

statement analysis and by calculating the important ratios in respect of liquidity and profitability

position.

3.2.5 Advisory Services

These services arise out of the close relationship between a factor and a client. Since the factors have

better knowledge and wide experience in the field of finance, and possess extensive credit information

about customer’s standing, they provide various advisory services on the matters relating to:

a. Customer’s preferences regarding the client’s products.

b. Changes in marketing policies/strategies of the competitors.

c. Suggest improvements in the procedures adopted for invoicing, delivery and sales return.

d. Helping the client in raising finance from banks/financial institutions

e. The factor provides his client with a periodical statement of the sanctioned limit, utilized credit and

balance outstanding. The following are provided regularly:

i. List of book debts taken over

ii. Book debts realised

iii. Age-wise classification of the debts

iv. Debts collected and due for collection

v. Debts purchased with recourse or without recourse etc.

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4 IMPORTANCE OF FACTORING

4.1 ADVANTAGES OF FACTORING: 1. It helps improve the current ratio. Improvement in the current ratio is an indication of improved

liquidity. Enables better working capital management. This will enable the unit to offer better credit

terms to its customers and increase orders.

2. It increases the turnover of stocks. The turnover of stock into cash is speeded up and this results in

larger turnover on the same investment.

3. It ensures prompt payment and reduction in debt.

4. It helps to reduce the risk. Present risk in bills financing like finance against accommodation bills can

be reduced to a minimum.

5. It helps avoid the collection department. The client need not undertake any responsibility of collecting

the dues from the buyers of the goods.

4.2 LIMITATIONS OF FACTORING: 1. Factoring is a high risk area, and it may result in over dependence on factoring, mismanagement, over

the trading of even dishonesty on behalf of the clients.

2. It is uneconomical for small companies with less turnover.

3. The factoring is not suitable for the company’s manufacturing and selling highly specialized items

because the factor may not have sufficient expertise to assess the credit risk.

4. The developing countries such as India are not able to be well versed in factoring. The reason is lack of

professionalism, non-acceptance of change and developement expertise.

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5 FINANCIAL ASPECTS OF FACTORING

5.1 FACTORING AND THE BALANCE SHEET The impact of factoring on the Balance Sheet is exhibited below:

Balance Sheet of ABC Co. Ltd. (Before Factoring)

Liabilities Amount(Rs) Assets Amount(Rs)

Bank Borrowings

Against Inventory

Against Receivables

Other Current Liabilities

Net Working Capital

7,00,000

4,00,000

4,00,000

5,00,000

Inventory

Receivables

Other Current

Assets

10,00,000

8,00,000

2,00,000

Total 20,00,000 Total 20,00,000

Current Ratio = Current Assets / Current Liabilities

= Rs. 20,00,000 / Rs. 15,00,000 = 1.33 : 1

Balance Sheet of ABC Co. Ltd. (After Factoring 80% of receivables)

Liabilities Amount(Rs) Assets Amount(Rs)

Bank Borrowings

Against Inventory

Against Receivables

Other Current Liabilities

Net Working Capital

7,00,000

-

1,60,000

5,00,000

Inventory

Due from factor

Other Current

Assets

10,00,000

1,60,000

2,00,000

Total 13,60,000 Total 13,60,000

Current Ratio = Current Assets / Current Liabilities

= Rs. 13,60,000 / Rs. 8,60,000

Reduction of Current Liabilities.

Improvement in Current Ratio and Efficiency.

Higher credit standing.

Reduction of cost and expenses.

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5.2 FACTORING AND PROFIT AND LOSS ACCOUNT The Benefits of factoring in terms of the profit and loss account are analysed asunder:

The factor performs basis functions like administration of the seller’s sales ledger, credit control,

collection of dues, etc. This saves the administration costs.

The improved liquidity position enables the firm to honour its obligations without any delay.

The improved credit standing helps the firm to get the benefits of lower purchase price, longer

credit period from suppliers, trade discount on bulk purchases, cash discount for early payment,

better market standing, quicker sanction of loans and advances, and better terms and

conditions while borrowing etc.

5.3 TREATMENT UNDER GAAP In the United States, under the Generally Accepted Accounting Principles receivables are considered

sold, under Statement of Financial Accounting Standards No. 140, when the buyer has "no recourse,".

Moreover, to treat the transaction as a sale under GAAP, the seller's monetary liability under any

"recourse" provision must be readily estimated at the time of the sale. Otherwise, the financial

transaction is treated as a secured loan, with the receivables used as collateral.

When a non-recourse transaction takes place, the accounts receivable balance is removed from the

statement of financial position. The corresponding debits include the expense recorded on the income

statement and the proceeds received from the factor.

5.4 FACTORING CHARGES Finance Charge: Finance charge is computed on the prepayment outstanding in the client’s account at

monthly intervals. Finance charges are only for financing that has been availed. These charges are

similar to the interest levied on the cash credit facilities in a bank.

Service fee: Service charge is a nominal charge levied at monthly intervals to cover the cost of services,

namely, collection, sales ledger management, and periodical MIS reports. The service fee is determined

on the basis of criteria such as the gross sales value, number of customers, the number of invoices and

credit notes, and the degree of credit risk represented by the customers or the transaction.

Both these charges taken together compare very favourably with the interest rates charged by banks

and financial institutions for short-term borrowings.

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6 PROSPECTS OF FACTORING IN INDIA

6.1 GROWTH OF THE FACTORING INDUSTRY IN INDIA The RBI formed a committee headed by CS Kalyansundaram, a former managing director of the State

Bank of India (SBI) to examine the need for and the scope of factoring organizations in India. The

committee submitted its report in December 1988 and recommended introduction of factoring services

in India. The RBI advised banks to take up factoring activity through a subsidiary.

6.1.1 Need for Factoring Services in India

There is sufficient scope for the introduction of factoring services in India, which would be

complementary to the services provided by banks.

The introduction of export factoring services in India would provide an additional facility to exporters.

With a view to attaining a balanced dispersal of risks, factors should offer their services to all industries

and all sectors of the economy.

6.1.2 RBI Guidelines

Banks are permitted to set up separate subsidiaries/invest in factoring companies.

Should not engage in financing of other companies or other factoring companies.

The investment of a bank cannot exceed in the aggregate 10% of paid-up capital and reserves of the

bank.

According to the RBI guidelines (2010), banks now with the prior approval of RBI can form subsidiary

companies for undertaking the factoring services and other incidental activities.

6.1.3 SBI Factors and Commercial Services

The State Bank of India, in association with the State Bank of Indore, the State Bank of Saurashtra, SIDBI,

and the Union Bank of India set up the SBI Factors and Commercial Services in February 1991. SBI

Factors commenced operations from April 1991. SBI factor was the first factoring company to be set up

in India. It has a 45% market share in this business. SBI Factors offers domestic, export, and import

factoring services.

SBI factor offers two types of products under domestic factoring:

i. Bill2Cash: - The seller invoices the goods to the buyer, assigns the same to SBI factors, and

receives prepayment up to 90 percent of the invoice value immediately.

ii. Cash4Purchase: Facilitates instant payment for purchases made and is generally sanctioned in

conjunction with receivable factoring facility or export factoring.

6.1.4 Canbank Factors Ltd.

Jointly promoted by the Canara Bank, Andhra Bank and SIDBI in August,1992.

Its Rs. 10 crore paid-up capital was contributed in the proportion of 60:20:20 by three

promoters respectively.

Initially operated in the south zone, but regional restrictions on their operations were

subsequently removed by the RBI.

Main services provided by the Canbank Factors Ltd are domestic factoring and invoice

discounting.

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6.2 REASONS FOR SLOW GROWTH The overall worldwide growth in factoring is estimated at 12%. Europe has the largest market,

representing 64% of the world volumes with a growth of 18% during the year. America's growth was

10%, whereas Australia recorded impressive growth of 40%. Asia saw a fall in volume.

The growth trends mentioned above support the fact that there is enormous scope for expansion

worldwide and India is no exception to this. The potential in India is estimated at an annual turnover of

Rs. 15000 to Rs. 20000 crores, but a large portion of the same is untapped because of the following

reasons:

i. Lack of a credit appraisal system and authentic information about customers and clients restricts

the growth of this business. As against this, in the UK and the USA, companies ,such as the Dunn

and Bradstreet, engage in credit appraisal systems.

ii. Higher stamp duty on the assigning of the debt increases the cost of the client which reduces

factoring arrangements.

iii. Non availability of permits to factoring companies for raising their debt restricts their financing

capacity and thereby growth of the market.

iv. Being registered as NBFCs, factoring companies are not eligible for refinance which limits the

extension of this facility to the exporters on open account sales. This restricts the growth of the

market.

6.3 SUGGESTIONS: i. Eliminate or reduce stamp duty.

ii. Develop a separate company which would give a true and fair credit appraisal report.

iii. Debt raising capacity of factoring companies should be increased.

iv. A better legal framework

v. Factoring companies should be given the status of financial institutions so they are eligible for

refinance which, in turn, would provide an impetus to the growth of the factoring market.

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7 REFERENCES

1. BHARTI V. PATHAK, INDIAN FINANCIAL SYSTEM, PG. 744-750

2. HTTP://WWW.ENTREPRENEUR.COM/ENCYCLOPEDIA/FACTORING

3. HTTP://WWW.YOURARTICLELIBRARY.COM/ECONOMICS/FACTORING-SILENT-FEATURES-TYPES-STEPS-ADVANTAGE-

AND-LIMITATIONS/23514/

4. CHAPTER 3 - FACTORING: THEORETICAL FRAMEWORK, MANAGEMENT OF FINANCIAL SERVICES, RAI

UNIVERSITY

5. HTTP://WWW.UKESSAYS.CO.UK/ESSAYS/FINANCE/GROWTH-OF-FACTORING-IN-INDIA.PHP

6. HTTP://EN.WIKIPEDIA.ORG/WIKI/FACTORING_%28FINANCE%29#TREATMENT_UNDER_GAAP

7. HTTP://WWW.SBIGLOBAL.IN/ABOUT/ABOUTGTF.HTM

8. WWW.CANBANKFACTORS.COM/

9. HTTP://WWW.ENTREPRENEURINDIA.COM/ARTICLE/MANAGING-A-BUSINESS/FINANCE/FACTORING-AN-OPTION-OF-

FINANCING-304/

10. HTTP://WWW.THEINTERNATIONALJOURNAL.ORG/OJS/INDEX.PHP?JOURNAL=TIJ&PAGE=ARTICLE&OP=VIEW&PATH[]

=1260

11. ANIRBAN GHATAK, ROLE OF FACTORING IN FINANCING SMES IN INDIA, TIJRP RESEARCH JOURNAL OF SOCIAL

SCIENCE AND MANAGEMENT.