What is factoring?
Factoring is a service that covers the financing and collection of account receivables in domestic and international trade. It is a cash management tool for companies where long receivables are a part of business cycle. It is the conversion of credit sales into cash.
In factoring, a financial institution (factor) buys the accounts receivable of a company (Client) and pays up to 80% 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. The account receivable in factoring can either be for a product or service.
Examples are factoring against goods purchased, factoring for construction services (usually for government contracts), factoring against medical insurance etc. Let us see how factoring is done against an invoice of goods purchased.
Characteristics of factoring
- Usually period for factoring is 90 to 150 days. Sometimes more than 150 days.
- Costly source of finance compared to other sources of short term borrowings.
- Credit worthiness is evaluated based on financial strength of customer (debtor). Therefore ideal for new and emerging firms without strong financials.
- Bad debts are considered for factoring.
- Credit rating is not mandatory. But factoring companies usually carries out credit risk analysis before entering into agreement.
- Method of off balance sheet financing.
- Cost of factoring=finance cost + operating cost. Factoring cost depends on transaction size, financial strength of the customer etc. varies from 1.5% to 3% per month depending upon the financial strength of 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 normal cost is charged.
How is factoring different from a bank loan?
1. Credit decision in factoring is based on receivables rather than other factors like how long the company has been in business, working capital and personal credit score.
2. Factoring is not a loan; it is the purchase of financial asset.
3. Bank loan involves two parties whereas factoring involves three-buyer, exporter and factor.
**There is some misconception regarding factoring like people believe factors are a lender of last resort but that is not true because exporters seeking out factoring are often in the beginning stages of growth. At first glance, factoring appears to be expensive but does a lot more; in essence, factoring replaces the accounts receivables and credit department.
- turns receivables instantly into cash
- provides credit protection for receivables
- helps meet increasing sales demand and expand
- Saves time as invoice financing company collects money itself
- may lead to ruined relations with customers if factor engages in aggressive or unprofessional practices when collecting accounts.
- cost involved in factoring agreement may be more than cost of other methods of financing
Different types of Factoring
- Disclosed and Undisclosed
- Recourse and Non recourse
A single factoring company may not offer all these services.
o Client's customers are notified of factoring agreement. Can either be recourse or non recourse.
o factor may or may not be responsible for the collection of debts depending on whether it is recourse or non recourse.
client's customers are not notified of the factoring arrangement. Sales ledger administration and collection of debts are undertaken by client himself. Client has to pay the amount to the factor irrespective of whether customer has paid or not.
client undertakes to collect debts from customer. If customer dosent pay amount on maturity, factor will recover it from client. Offered at lower interest rate since risk by factor is low. Balance amount is paid to client when customer pays factor.
factor undertakes to collect debts from customer. Balance amount is paid to client at the end of credit period or when the customer pays factor whichever comes first. advantage is that continuous factoring will eliminate need for credit and collection departments.
Factoring companies in India
· Canbank Factors Limited
· SBI Factors and Commercial Services Pvt. Ltd
· The Hongkong and Shanghai Banking Corporation Ltd
· Foremost Factors Limited
· Global Trade Finance Limited
· Export Credit Guarantee Corporation of India Ltd
· Citibank NA, India
· Small Industries Development Bank of India (SIDBI)
· Standard Chartered Bank
What is forfeiting?
The forfeiting owes its origin to a French term ‘a forfait’ which means to forfeit (or surrender) ones’ rights on something to someone else. It is a mechanism of financing exports:
a. by discounting export receivables
b. evidenced by bills of exchanges or promissory notes
c. without recourse to seller (viz; exporter)
d. carrying medium to long-term maturities
e. on a fixed rate basis upto 100% of contract value.
In other words, it is trade finance extended by a forfaiter to an exporter seller for an export/sale transaction involving deferred payment terms over a long period at a firm rate of discount. Forfaiting is generally extended for export of capital goods, commodities and services where importer insists on supplies on credit terms. Recourse to forfaiting usually takes place where the credit is for long date maturities and there is no prohibition for extending the facility where the credits are maturing in periods less than one year.
Parties to Forfaiting
There are five parties in a transaction of forfaiting.
iii. Exporter’s bank
iv. Importer’s bank
v. The forfaiter.
1. exporter and importer negotiate proposed export sale contract. Then exporter approaches forfaiter to ascertain terms of forfaiting.
forfaiter collects details about importer, supply and credit terms, documentation etc.
· ascertains country and credit risk involved.
· quotes discount rate.
5. exporter then quotes a contract price to overseas buyer by loading discount rate, commitment fee etc. On the sale price of goods to be exported.
6. exporter and forfaiter sign a contract.
7. Export takes place against documents guaranteed by importer’s bank.
8. exporter discounts bill with forfaiter and latter presents the same to importer for payment on due date or even sell it in secondary market.
1. Forfaiting transaction is usually covered either by a promissory note or bills of exchange & are guaranteed by a bank.
3. Bills of exchange may be ‘availed by’ importer’s bank. ‘Aval’ is an endorsement made on bills of exchange or promissory note by the guaranteeing bank by writing ‘per aval’ on these documents under proper authentication.
Costs of forfaiting
1. Commitment fee, payable by exporter to forfeiter ‘for latter’s’ commitment to execute a specific forfeiting transaction at a firm discount rate with in a specified time.
2. Discount fee, interest payable by exporter for entire period of credit involved and deducted by forfaiter from amount paid to exporter against availised promissory notes or bills of exchange.
3. Documentation fee.
Benefits of forfaiting
1. frees exporter from political or commercial risks from abroad.
2. offers ‘without recourse’ finance to an exporter. does not effect exporter’s borrowing limits/capacity.
3. relieves exporter from botheration of credit administration and collection problems.
4. Forfaiting is specific to a transaction. It does not require long term banking relationship with forfaiter.
5. Exporter saves money on insurance costs because forfeiting eliminates need for export credit insurance.
· Firms resorting to factoring have added attraction of ready source of short-term funds. This improves cash flow and is invaluable as it leads to a higher level of activity resulting in increased profitability.
· By offloading the sales accounting and administration, management has more time for planning, running and improving the business, and exploiting opportunities, The reduction in overheads brought about by factor’s administration of sales ledger result in interest savings and contribute towards cost savings.
· costlier to in-house management of receivables, specially for large firms which have access to similar sources of funds as the factors themselves and which on account of their size have well organised credit and receivable management.
· perceived as an expensive form of financing and also as finance of the last resort. This tends to have a deleterious effect on the creditworthiness of the company in the market.
Major players in India
The first factoring company was started by the SBI in 1991 namely Factors and Commercial Ltd. (SBI FACS) followed by Canara Bank and PNB, setting the subsidiaries for the purpose. While the SBI would provide such services in the Western region, the RBI has permitted the Canara Bank and PNB to concentrate on the Southern and Northern regions of the country, for providing such services for the customers. The major players since 1991 are Canbank Factors, SBI Factors and later Foremost Factors. The new entrants in the market include ICICI, HSBC and Global Trade Finance. Canback Factors leads in the domestic market with about 65%-70% of the share.
The factoring service has not developed to any significant extent in India.