FACTORING Vishwanath S R

Factoring involves a continuing arrangement between the company and a financial

institution, called factor, to assume the credit and collection functions of the company.
The factor purchases the client’s receivables as and when they arise, maintains the
sales ledger, attends to other book keeping duties relating to accounts receivable
and performs other auxiliary functions.
Factors are usually subsidiaries of banks or private financial companies.
The important point is that factoring is a continuing arrangement and not related to
specific transactions.
This means that the factor handles all the receivables arising out of the credit sales of
the company and not just some specific bills or invoices as is done in bill discounting
agreement.
TYPES OF FACTORING

Recourse factoring: The factor purchases the receivables on the condition that any
loss arising out of irrecoverable receivables will be borne by the client.
In other words, the factor has recourse to the client if the receivables purchased turn
out to be irrecoverable.
Non-recourse factoring or full factoring: The factor has no recourse to the client if
the receivables are not recovered, i.e. the client gets total credit protection.
In this type of factoring, all the components of service viz. short-term finance,
administration of sales ledger and credit protection are available to the client.
Maturity factoring: Under this type of factoring arrangement, the factor does not make any
advance or pre-payment.
The factor pays the client either on a guaranteed payment date or on the date of collection
from the customer.
This is as opposed to “Advance factoring” where the factor makes prepayment of around
80% of the invoice value to the client.
Invoice factoring: This is not exactly a form of factoring, as it does not include the service
element of factoring.
Under this arrangement, the factor provides a prepayment to the client against the purchase
of accounts receivables and collects interest (service charges) for the period extending from
the date of prepayment to the date of collection.
The sales ledger administration and collection are carried out by the client.
Advance factoring: Under Advance factoring arrangement, the factor provides an
advance against the uncollected and non-due receivables to the firm.
Maturity factoring: Factoring arrangement that only provide assistance with regard
to collections or insurance against bad debts is called maturity factoring.
Undisclosed or Confidential factoring: Under confidential factoring, the customer is
not informed of the factoring arrangement. The firm may collect dues from the
customer on its own or instruct to make remit at some other address.
TN-1
EXAMPLE
A manufacturing firm sells Rs 1 m per month on credit with terms of 2/10; Net 60.
Historically, 20 % of the accounts receivable are discounted and paid on the 10th, the
bad debt loss rate is 1% and credit department costs Rs 10000, 2 % of the face
amount of accounts receivable, are paid on the 30th.
It is expected that 5 % of the accounts receivable will be disputed and not paid until
the 120th day after sale
A factor offers to buy all of the manufacturer's accounts receivable on a maturity
basis charging a 1.5% fee.
The factor will make a cash settlement on the net date (60th ) less a 5% holdback for
non-payment due to product quality disputes .
It is expected that all such disputes will be settled and the factor will release the
holdback on the 120th day.
The manufacturer has a 10% opportunity rate of return.
TN-2
The present value analysis suggests that the manufacturer should factor its accounts
receivable.
STEPS INVOLVED IN EVALUATING THE FACTORING
OPTION
Calculate the costs as % of the total turnover as agreed upon by the collection
agency and the company. For the purpose of analysis the costs can be taken at 1 %,
1.5 % and 2.5 % of the total turnover.
The benefits would comprise of the gains in terms of opportunity costs, salaries given
to the collection staff, cash discounts given to the debtors for early payment of debts
and overdraft interest to be paid in cases where outflows exceed inflows.
The computation of opportunity costs can be done on the basis of ACP of 30 days
and 60 days. In other words it has been assumed that the factor would pay the
company in 30 days or 60 days after the sale. The gain to the company is the
interest cost saved on the difference between the number of days actually taken to
collect the debt and the normal period (30 or 60 days)
COST BENEFIT ANALYSIS
The cost-benefit analysis of an agreement can made under the following assumptions
(for e.g.):
Opportunity costs can be 8%, 11% and 14% depending on the investment options
available to the company. An opportunity cost of 14 % has been assumed.
Service charges can be 1%, 1.5 % and 2.5 % .
The normal collection period is 30 days
TN-3
On an aggregate basis the company can gain Rs 80 L - 1.47 cr for different levels of
service charges ranging from 1-2.5 % assuming an opportunity cost of 14 %. The
savings are lower if an opportunity cost of 11 % is assumed. The analysis suggests
that factoring:
Is profitable in the western region under all conditions and in north when the service
charges are 1% or 1.5 %.
Is not profitable in the South and the East.