Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm's credit worthiness. Secondly, factoring is not a loan - it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three.
Factoring enables you to :
- Instantly turn your receivables into cash.
- Avial credit protection for your receivables.
- Take well informed credit decisions.
- Outsourse your sales ledger administration.
Factoring thus not only helps you in expanding your business ,but also provides you with an efficient collection mechanism and protection against bad debts.
The three parties directly involved are: the one who sells the receivable, the debtor, and the factor. The receivable is essentially a financial asset associated with the debtor's Liability to pay money owed to the seller (usually for work performed or goods sold). The seller then sells one or more of its invoices (the receivables) at a discount to the third party, the specialized financial organization (aka the factor), to obtain cash. The sale of the receivables essentially transfers ownership of the receivables to the factor, indicating the factor obtains all of the rights and risks associated with the receivables. Accordingly, the factor obtains the right to receive the payments made by the debtor for the invoice amount and must bear the loss if the debtor does not pay the invoice amount. Usually, the account debtor is notified of the sale of the receivable, and the factor bills the debtor and makes all collections.
Critical to the factoring transaction, the seller should never collect the payments made by the account debtor, otherwise the seller could potentially risk further advances from the factor. There are three principal parts to the factoring transaction; a.) the advance, a percentage of the invoice face value that is paid to the seller upon submission, b.) the reserve, the remainder of the total invoice amount held until the payment by the account debtor is made and c.) the fee, the cost associated with the transaction which is deducted from the reserve prior to it being paid back the seller. Sometimes the factor charges the seller a service charge, as well as interest based on how long the factor must wait to receive payments from the debtor.
CHARACTERISTICS OF FACTORING
- Usually the period for factoring is 90 to 150 days. Some factoring companies allow even more than 150 days.
- Factoring is considered to be a costly source of finance compared to other sources of short term borrowings.
- Factoring receivables is an ideal financial solution for new and emerging firms without strong financials. This is because credit worthiness is evaluated based on the financial strength of the customer (debtor). Hence these companies can leverage on the financial strength of their customers.
- Bad debts will not be considered for factoring.
- Credit rating is not mandatory. But the factoring companies usually carry out credit risk analysis before entering into the agreement.
- Factoring is a method of off balance sheet financing.
- Cost of factoring=finance cost + operating cost. Factoring cost vary according to the transaction size, financial strength of the customer etc. The cost of factoring varies from 1.5% to 3% per month depending upon the financial strength of the client's customer.
- Indian firms offer factoring for invoices as low as 1000Rs
- For delayed payments beyond the approved credit period, penal charge of around 1-2% per month over and above the normal cost is charged (it varies like 1% for the first month and 2% afterwards).
DIFFERENT TYPES OF FACTORING
- Disclosed and Undisclosed
- Recourse and Non recourse
A single factoring company may not offer all these services.
In disclosed factoring client's customers are notified of the factoring agreement. Disclosed type can either be recourse or non recourse.
In undisclosed factoring, client's customers are not notified of the factoring arrangement. Sales ledger administration and collection of debts are undertaken by the client himself. Client has to pay the amount to the factor irrespective of whether customer has paid or not. But in disclosed type factor may or may not be responsible for the collection of debts depending on whether it is recourse or non recourse.
In recourse factoring, client undertakes to collect the debts from the customer. If the customer don't pay the amount on maturity, factor will recover the amount from the client. This is the most common type of factoring. Recourse factoring is offered at a lower interest rate since the risk by the factor is low. Balance amount is paid to client when the customer pays the factor.
NON RECOURSE FACTORING
In non recourse factoring, factor undertakes to collect the debts from the customer. Balance amount is paid to client at the end of the credit period or when the customer pays the factor whichever comes first. The advantage of non recourse factoring is that continuous factoring will eliminate the need for credit and collection departments in the organization.
ADVANTAGES AND DISADVANTAGES OF FACTORING
There are numerous advantages to debt factoring, but also some potential drawbacks.
Factoring provides a large and quick boost to cash flow. This may be very valuable for businesses that are short of working capital. A business that is owed £500,000 may be able to get £400,000 or more in just a few days.
- there are many factoring companies, so prices are usually competitive.
- it can be a cost-effective way of outsourcing your sales ledger while freeing up your time to manage the business.
- it assists smoother cash flow and financial planning.
- some customers may respect factors and pay more quickly.
- you may be given useful information about the credit standing of your customers and they can help you to negotiate better terms with your suppliers.
- factors can prove an excellent strategic as well as financial resource when planning business growth.
- you will be protected from bad debts if you choose non-recourse factoring cash is released as soon as orders are invoiced and is available for capital investment and funding of your next orders.
Queries and disputes may have to be referred on. For this reason, factoring works best when a business is efficient and there are few disputes and queries.
- The cost will mean a reduction in your profit margin on each order or service fulfilment.
- It may reduce the scope for borrowing - book debts will not be available as security.
- Factors may want to vet your customers and influence the way that you do business.
- It may be difficult to end an arrangement with a factor as you will have to pay off any money they have advanced you on invoices if the customer has not paid them yet.
- Some customers may prefer to deal directly with you.
- How the factor deals with your customers will affect what your customers think of you. Make sure you use a reputable company that will not damage your reputation.
- You have to pay extra to remove your liability for bad debtors.
Reason for Factoring
Factoring is a method used by a firm to obtain Cash when the available Cash Balance held by the firm is insufficient to meet current obligations and accommodate its other cash needs, such as new orders or contracts. The use of Factoring to obtain the Cash needed to accommodate the firm's immediate Cash needs will allow the firm to maintain a smaller ongoing Cash Balance. By reducing the size of its Cash Balances, more money is made available for investment in the firm's growth. A company sells its invoices at a discount to their face value when it calculates that it will be better off using the proceeds to bolster its own growth than it would be by effectively functioning as its "customer's bank."
Accordingly, Factoring occurs when the rate of return on the proceeds invested in production exceed the costs associated with Factoring the Receivables. Therefore, the trade off between the return the firm earns on investment in production and the cost of utilizing a Factor is crucial in determining both the extent Factoring is used and the quantity of Cash the firm holds on hand.
Many businesses have Cash Flow that varies. A business might have a relatively large Cash Flow in one period, and might have a relatively small Cash Flow in another period. Because of this, firms find it necessary to both maintain a Cash Balance on hand, and to use such methods as Factoring, in order to enable them to cover their Short Term cash needs in those periods in which these needs exceed the Cash Flow. Each business must then decide how much it wants to depend on Factoring to cover short falls in Cash, and how large a Cash Balance it wants to maintain in order to ensure it has enough Cash on hand during periods of low Cash Flow.
Generally, the variability in the cash flow will determine the size of the Cash Balance a business will tend to hold as well as the extent it may have to depend on such financial mechanisms as Factoring.
Cash flow variability is directly related to 2 factors:
- The extent Cash Flow can change,
- The length of time Cash Flow can remain at a below average level.
If cash flow can decrease drastically, the business will find it needs large amounts of cash from either existing Cash Balances or from a Factor to cover its obligations during this period of time. Likewise, the longer a relatively low cash flow can last, the more cash is needed from another source (Cash Balances or a Factor) to cover its obligations during this time. As indicated, the business must balance the opportunity cost of losing a return on the Cash that it could otherwise invest, against the costs associated with the use of Factoring.
The Cash Balance a business holds is essentially a Demand for Transactions Money. As stated, the size of the Cash Balance the firm decides to hold is directly related to its unwillingness to pay the costs necessary to use a Factor to finance its short term cash needs. The problem faced by the business in deciding the size of the Cash Balance it wants to maintain on hand is similar to the decision it faces when it decides how much physical inventory it should maintain. In this situation, the business must balance the cost of obtaining cash proceeds from a Factor against the opportunity cost of the losing the Rate of Return it earns on investment within its business.
- To know who are providing the factoring facility.
- To know the condition of the firms using the factoring facility.
- To know the factors responsible for the growth of factoring in india.
- To know the effect of growth of factoring in india.
- To know as to how the firms are getting benefit by using the factoring facility.
REVIEW OF LITERATURE
FACTORING: Here's to the next 1,000 years!
Ron Kissling is Managing Principal of The Pyramid Consortium, a financial services consulting group, and a former chairman of Factors Chain International. If anyone knows about factoring, he does. He talks here about background and recent trends in the industry.
Factoring has prospered for thousands of years due to its adaptability. Historically, the distinctive qualities of this product have proven it to be one of the most flexible finance tools in supporting trade. Today, factoring supports almost US$1 trillion of annual trade from over 60 countries.
The definition of factoring can be found in the work of The International Institute for the Unification of Private Law that is commonly known as UNIDROIT. UNIDROIT was formed over 25 years ago to promote the international congruity of commercial law.
According to UNIDROIT, factoring must have three characteristics.
First, there must be the provision for the assignment of debts arising from the sale of goods or services within a commercial contract. Factoring is not usually associated with consumer debts.
Second, there must be a stipulation to provide for notification to be given to the debtors of the assignments.
Third, the 'factor' (the company performing the factoring service) must perform at least two of the following services:
- debtor account maintenance
- debt collection
- protection against default of the debtors.
These characteristics provide the flexibility for factoring to be used either as a finance tool or an administrative resource to support trade. The two are typically combined to create a formidable trade product with multiple benefits.
There are numerous variations and names by which factoring is known. Factoring's adaptability to different country's legal, economic and banking environments is a logical outgrowth of its unique characteristics and services. The capacity to add or remove services when developing factoring for a specific need has increased its penetration into new markets.
This flexibility can lead to misunderstandings. As variations of factoring are given new names there is often confusion regarding the type of product being offered. The following names are examples that are used with factoring depending upon the product features: maturity, non-recourse, recourse, settlement date, invoice discounting, and bulk factoring.
Factoring with identical benefits in one country may be called something different in another. Invoice discounting, also known as confidential factoring in most of Europe, is known in the United States as accounts receivable financing. A complete list of names and service variances with regard to factoring would be voluminous.
Peat Marwick Mitchell describes factoring as "finance linked to management service." Factoring techniques, usage by British corporations, and methods for selecting a factoring company are discussed, and 24 factoring firms in and around London are listed. In an Accountancy magazine survey of the top 1000 British corporations according to The Times, only three of the 60 firms responding admitted to using a factor to obtain financing; however, 27 of these respondents viewed factoring as a means for improving cash flow. Contractual forms of factoring (recourse versus nonrecourse factoring), types of factoring (agency factoring, bulk factoring, invoice factoring, and invoice discounting), and the three services offered by factors (finance, risk control, and sales ledger administration) are explained. Six rules to follow when selecting a factor are provided: (1) examine the proposed computation of factor service fees relative to company debt amounts, (2) determine whether the factor is to be paid before the company receives funds from the factor, (3) review calculations related to final due dates of debts sold to factors, (4) ensure the factor agreement provides for adjustment of the maturity date system, (5) ascertain whether the factor offers prepayment guarantees for a percentage of the debts handled, and (6) include a period of notice for terminating the agreement.
The design is the structure of any scientific work. It gives direction and systematizes the research.
There are two main approaches to a research problem:
- Quantitative Research
- Qualitative Research
PRIMARY DATA -Primary data is basically the live data which is collected on field while interacting with the customers and is shown as list of questions.
SECONDARY DATA- It have been used for the research like through internet ,newspaper, magazines.
Pie charts are really useful tools for every research to show the result in a well clear, ease and simple way.
It need not necessary for any observer to read all the theoretical detail, simple on seeing the charts anybody could know that what is being said.
WORKING OF FACTORING
Factoring provides a fast prepayment against your sales ledger. It allows you, at a cost, to flexibly increase your working capital and improve cash flow.
Factoring is offered to businesses trading with other businesses on credit terms. It is not normally available to retailers or to cash traders.
- First, importer places an order with the exporter
- Secondly, exporter gives the details of the transaction to the factor
- Thirdly, exporter dispatches the goods to the importer and sends an invoice well to pay the amount on due date to the factor
- Exporter submits the copy of invoice to the factor
- Factor pays the amount to exporter
- Customer pays the amount to the factor on due date
- Factor pays the balance to client
When factoring starts
Factors can be independent, or subsidiaries of major banks and financial institutions. Whatever their background, they will want to meet you, visit your business, review your financial situation and study your business plan to evaluate your suitability for a factoring facility.
Credit limits might be required - if so, you must agree how they will operate. After signing the agreement, the factor will typically agree to advance up to 85 per cent of approved invoices. Payment is usually made within 24 hours. Usually all sales go through the factor. Check the notification period - most factors require three months' notice to end the service, but some require longer. Negotiate if you are not happy with the notice period.Factoring is a complex, long-term agreement. It is advisable to consult your solicitor on the legal and financial implications of factoring.
When an invoice is raised
- You raise an invoice, which has instructions to pay the factor directly and send it to the customer. Send a copy of it to the factor.
- The factor pays an agreed percentage of the invoice to you.
- The factor issues statements to the customer on your behalf. It operates credit control procedures including telephoning the customer if necessary.
When an invoice is paid by the customer
- The customer should pay 100 per cent of the invoice directly to the factor.
- The factor pays the balance of the invoice to you. Fees and interest will be deducted from the payment.
When an invoice is not paid
If an invoice is not paid, responsibility for paying the debt will depend on the type of agreement - either recourse factoring or non-recourse factoring.
CHOOSING A FACTOR:
There are a variety of factors to choose from. Some are subsidiaries of major banks and financial institutions, others are independent.
You need to be able to make an informed choice, so it's worth approaching more than one factor before making a decision.
The Asset Based Finance Association (ABFA) will supply a list of factors, and also give details of their turnover requirements and the services they offer. There are a number of factoring brokers that will negotiate on your behalf. They may not charge you as they will receive commission from the factoring company.
MAKING A BUSINESS SUITABLE FOR FACTORING:
Your business may be suitable for factoring if it has:
- an annual turnover of at least £50,000, although some factors will consider start-ups and smaller businesses.
- more than just a few customers.
- no single customer accounts for more than about a third of turnover.
- customers that accept the standard payment terms for the industry.
- customers that accept a reasonable period of credit.
MAKING A BUSINESS UNSUITABLE FOR FACTORING:
Your business may not be suitable for factoring if it:
- sells to the public - factoring is only available for sales to commercial customers.
- has too many small invoices
- has too many disputes and queries
- is not a sound, reputable and trustworthy business
- has customers that make part payments or stage payments.
Factoring's origins lie in the financing of trade, particularly international trade. Factoring as a fact of business life was underway in England prior to 1400. It appears to be closely related to early merchant banking activities. The latter however evolved by extension to non-trade related financing such as sovereign debt. Like all financial instruments, factoring evolved over centuries. This was driven by changes in the organization of companies; technology, particularly air travel and non-face to face communications technologies starting with the telegraph, followed by the telephone and then computers. These also drove and were driven by modifications of the common law framework in England and the United States. Governments were latecomers to the facilitation of trade financed by factors. English common law originally held that unless the debtor was notified, the assignment between the seller of invoices and the factor was not valid. The Canadian Federal Government legislation governing the assignment of moneys owed by it still reflects this stance as does provincial government legislation modeled after it.
As late as the current century the courts have hear arguments that without notification of the debtor the assignment was not valid. In the United States it was only in 1949 that the majority of state governments had adopted a rule that the debtor did not have to be notified thus opening up the possibility of non-notification factoring arrangements.
Originally the industry took physical possession of the goods, provided cash advances to the producer, financed the credit extended to the buyer and insured the credit strength of the buyer. In England the control over the trade thus obtained resulted in an Act of Parliament in 1696 to mitigate the monopoly power of the factors. With the development of larger firms who built their own sales forces, distribution channels, and knowledge of the financial strength of their customers, the needs for factoring services were reshaped and the industry became more specialized.
By the twentieth century in the United States factoring became the predominant form of financing working capital for the then high growth rate textile industry. In part this occurred because of the structure of the US banking system with its myriad of small banks and consequent limitations on the amount that could be advanced prudently by any one of them to a firm. In Canada, with its national banks the limitations were far less restrictive and thus factoring did not develop as widely as in the US.
Even then factoring also became the dominant form of financing in the Canadian textile industry.
Today factoring's rationale still includes the financial task of advancing funds to smaller rapidly growing firms who sell to larger more creditworthy organizations. While almost never taking possession of the goods sold, factors offer various combinations of money and supportive services when advancing funds.
Growth of factoring in India has been far from slow. According to a World Bank report, India's factoring activity grew by over 800% between 1998 and 2003. According to the latest report from Factors Chain International (FCI), the Indian factoring market has grown from Euro 1290 million to Euro 3560 million (a growth of 176%) between 2002 and 2006. There are signs that show that the Indian factoring market is maturing fast. In fact, GTF is the founding member of Factors Association of India (FAI), a grouping of factoring companies operating in India. FAI is a strategic conglomeration that will ensure wider dissemination of knowledge of factoring in India.
There are no insurmountable stumbling blocks for growth in India. However, there are certain minor hiccups that have come in the way of unleashing the full potential of factoring in India. For instance, India lacks a proper legal framework to protect factoring services. Factoring companies need legal protection as all advances are uncollateralized. We can't initiate summary proceedings as we are categorized as a Non Banking Finance Company (NBFC). There is no protection under either Debt Recovery Tribunal (DRT) or Securitisation Act. Another issue that needs to be addressed is stamp duty. When a debt is assigned, the stamp duty has to be paid. This duty is decided by the respective State Governments and it does not have a uniform structure.
IN 2008, the total world volume for factoring increased by 2 per cent, compared to almost 15 per cent in 2007. We can see that Europe has shown an upward trend till 2007, and then a downward trend. If we see the trend of Asia, it is stagnant in initial years i.e. till 2006 and then has shown a little upward trend till 2007. After 2007, a notable increase is seen and thus factoring volume crossed 200 billion. Africa and Australia showed a similar and a stagnant trend. The factoring volume of America is very similar to Asia, but after 2007, Americas factoring volume is seen stagnant only The overall results illustrate that exporters and importers, around the world, are becoming more and more familiar with the advantages to be derived from a factoring arrangement: working capital, credit risk protection and collection service for the exporter.
GROWTH OF THE FACTORING INDUSTRY IN INDIA
SLOW GROWTH REASONS
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 cr, but large portion is untapped because of the following reasons
Factoring is a standalone Product: Factoring is similar to Bill Discounting- What people fail to understand is that though it is similar only in one aspect, i.e., both provides short term finance against receivables, factoring also provides a package of other services.
Non-Recourse factoring is almost missing: Recourse factoring only provides financing but not credit covers, whereas in case of non-recourse factoring, in the event of default of a customer, the factor will bear the risk of bad debt. However, the facility, which will attract more clients, is almost missing, in India Customers are still not aware of factoring Services: Factors have not been successful in creating awareness about the concept of factoring. The difference between factoring and bills discounting is still not clearly understood. The customers are still not aware of the extra benefits and services they can enjoy through factoring; they are not demanding these services from factoring service providers.
Bankers do not Permit their Customer to Shift their Business to Factors: Every businessman invariably has dealings with a bank. Hence, his banker does not permit him to shift his account receivables business to a factor, but promises to meet his requirements.
Network of branches is poor for factoring.
FUTURE PLANS OF GROWTH OF FACTORING IN INDIA:
The long held view that India is just a services hub is also changing fast. India's manufacturing sector is making rapid strides and could really be the base for the next wave of growth. There is a well-known saying in investment circles that you should invest in an emerging economy when the first international airport is built and you should exit when the second airport comes up ie, exit at the first signal of over-investment. China may soon reach the second airport stage. In that event.
- India would make an even bigger potential growth story in the years to come. India is evolving from a command economy focused on self-sufficiency to becoming a key link in the global economic chain.
- India is well positioned by geography, language, and historical association to service customers in advanced economies. India also has historical trading links with the Middle East and Africa as well as its own South Asian neighbors.
- As the manufacturing base of a country expands, the scope for factoring also increases. At the micro level, factoring is tailor-made for a company on the path of high-octane growth; just as at the macro level it is suited for a growing economy like India.
- There is only one direction in which factoring can go in India: upwards. As the awareness level about the benefits of factoring increases, factoring will spread its wings across the length and breadth of the country.
- The basic disadvantage of is that it may lead to ruined relations with the customers especially if factor engages in aggressive or unprofessional practices when collecting accounts
- Cost is another disadvantage, cost involved in factoring agreement may be more than the cost of other methods of financing available in the business.
RECOMMENDATIONS AND CONCLUSION
Factoring should be used by the firms by keeping in view the financial position of the factor.
At the end it is to be concluded that factoring is now gaining its importance in India slowly with the increase in customer's access to benefits of factoring . India's future in factoring business seems to be luring on the facts obtained regarding the fast growth of 174 % in only 4 years .So for factoring to be succesfull in India government regulation/ policies need to be modified further so that more and more private players can come forward to start up their factoring business in India .Customer awareness about benefits of factoring is to be increased further to fight back the global leaders in factoring business.
List of Books refered:
- Financial Services - By M.Y Khan
- Financial Management - By I.M Pandey