Factoring Services

What is Factoring

• 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.

• 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 (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.

• In factoring, a financial institution (factor) buys the accounts receivable of a company (Client) and pays up to 80%(rarely up to 90%) of the amount immediately on agreement.

• Factoring company pays the remaining amount (Balance 20%-finance cost-operating cost) to the client when the customer pays the debt.

• Collection of debt from the customer is done either by the factor or the client depending upon the type of factoring.

• RBI issued guidelines for factoring services in 1990.

• The first factoring company SBI Factors and Commercial Ltd. Started operation in April, 1991.

Factoring companies in India

• Canbank Factors Limited: http://www.canbankfactors.com

• SBI Factors and Commercial Services Pvt. Ltd: http://www.sbifactors.com

• The Hongkong and Shanghai Banking Corporation Ltd: http://www.hsbc.co.in/1/2/corporate/trade-and-factoring-services

• Foremost Factors Limited: http://www.foremostfactors.net

• Global Trade Finance Limited: http://www.gtfindia.com

• Export Credit Guarantee Corporation of India Ltd: https://www.ecgc.in/Portal/productnservices/maturity/mfactoring.asp

• Citibank NA, India: http://www.citibank.co.in

• Small Industries Development Bank of India (SIDBI): http://www.sidbi.in/fac.asp

• Standard Chartered Bank: www.standardchartered.co.in

• A major advantage of Factoring is that it is a form of off balance sheet financing.

Forfaiting• In trade finance, forfaiting involves the

purchasing of receivables from exporters. • The forfaiter will take on all the risks involved

with the receivables. • It is different from the factoring operation in the

sense that forfaiting is a transaction based operation while factoring is a firm based operation –

• meaning, in factoring, a firm sells all its receivables while in forfaiting, the firm sells one of its transactions.

• Benefits for using forfaiting include eliminating risks (political, transfer and commercial risks) and improving cashflows. Increases cash flow.

• Forfaiting converts a credit-based transaction in to a cash transaction.

• Forfeiting is without recourse to the seller.

• The purchase is in the form of discounting the documents covering the entire risk of non payment in collection.

Recourse Factoring

• Under a recourse factoring arrangement, factor has recourse to the client if the receivables factored turns out to be irrecoverable.

• Factor does not assume credit risks associated with the receivables.

Non Recourse Factoring

• Under a non recourse factoring arrangement, factor does not have recourse to the client if the receivables factored turns out to be irrecoverable.

• The loss arising out of the irrecoverable receivables is borne by him, as a compensation for which he charges a higher commission.

Legal Aspects of Factoring

• There is no codified legal framework for factoring in India.

• Regulated under the law of Contract.• Legal relationship largely determined by the

terms of the contract.

Factoring versus Bill Discounting

• Bill discounting is always with recourse while factoring can be either with recourse or without recourse.

• Bill Discounting does not involve assignment of debt as is the case with factoring.

Bill Discounting

• Bill discounting is a fund based service provided by finance companies.

• An endorsed bill of exchange is handed over for ready money.

• The margin between the ready money and the face value of the bill is called ‘ Discounting of Bills’.

Bill of exchange

• Suppose a seller sells goods or merchandise to a buyer.

• In most cases, the buyer would like to purchase on credit.

• The seller draws a Bill of exchange of a given maturity on the buyer.

• The seller has now assumed the role of a creditor and is called the drawer of the Bill.

• The buyer who is the debtor, is called the drawee.

• The seller then sends the bill to the buyer who acknowledges it by writing his acceptance on the bill.

• In order to prevent misuse, the RBI placed several restrictions on the bill discounting mechanism.

• As a result, Bill discounting has substantially declined in importance.

Questions for Revision

• What is factoring ? How is it different from

– A Bank Loan– Forfaiting – Bill Discounting

The End