What is Factoring? Meaning, Definition, Types, Advantages, Disadvantages

What is Factoring?

Factoring refers to the phenomenon where a company (the adherent) sells its accounts receivables (the invoices showing the debts owed by its clients) to a financial service company (otherwise called factoring companies or factors) at a discounted rate (a little cheaper than the exact amount stated on the invoice), which will be paid immediately the status and creditworthiness of the debtors are ascertained by the factor.

This allows for the uninterrupted running of day-to-day operations in the company, while passing off the burden of a debt collector to the factor.

Factoring Meaning

In a simple definition, factoring is the conversion of credit sales into cash. Factoring is a financial option for the management of receivables.

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. The factoring company pays the remaining amount (Balance 20% 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.

We will see different types of factoring in this article. 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 where the government body is capable of paying back the debt in the sipulated period of factoring. Contractors submit invoices to get cash instantly), Let us see how factoring is done against an invoice of goods purchased.

Factoring Definition

Baresa defines factoring as the purchase of others receivables (debts) or financial instrument by which the factor finances companies on the basis of the future receivables that have arised from sales of goods and services in the domestic or international market for a fee.

According to Klapper, factoring is a type of supplier financing in which firms sell their credit-worthy accounts receivable at a discount (generally equal to interest plus service fees) and receive immediate cash.

Characteristics of Factoring

  1. Usually the period for factoring is 90 to 150 days. Some factoring companies allow even more than 150 days.

  2. Factoring is considered to be a costly source of finance compared to othersources of shoft term borrowings.

  3. Factoring receiwbles is an ideal financial solution for new and emerging firms.This is because credit worthiness is evaluated based on the financial strength of the customer (debtor). Hence these companies can leverage on the financialstrength of their customers.

  4. Bad debts will not be considered for factoring

  5. Credit rating is not mandatory. But the factoring companies usually {nY outcredit risk analysis before entering into the agreement.
  6. Factoring is a method of off balance sheet financing.

  7. Cost of factoring = finance cost + operating cost. Factoring cost vary according tothe transactiQn size, financial strength of the customer etc. The cost of factoring varies from 1.5% to 3% pd month depending upon the finarrcial sffiengrth ofclient’s ctrstomer.

  8. Indian firms oftr factoring for invoies as low as Rs. 1000

For delayed payments, beyond the approved credit period, a penal charge of around 1-2% per month over and above the normal cost is charged (it varies tike 1% for the first month and 2% afterwards).

Types of Factoring

Types of Factoring
Types of Factoring

Disclosed Factoring

In disclosed factoring clients customers are notified of the factoring agreement. Disclosed types can either be recourse or non-recourse factoring.

Undisclosed Factoring

In undisclosed factoring, clients customers are not notified of the factoring arrangement. Sales ledger administration and collection of debt are undertaken by the client himself. The client has to pay the amount to the factor irrespective of whether the 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.

Recourse Factoring

In recourse factoring, the client undertakes to collect the debt from the customer. If customer doesn’t pay the amount on maturity, the factor will recover the amount the client. This is the most common type of factoring.

Recourse factoring is offered lower interest rates since the risk by the factor is low. Balance amount is paidthe client when the customer pays the factor.

Non Recourse Factoring

In non recourse factoring, the factors undertake to collect the debts from the customer. The Balance amount is paid to the 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 orgnization.

Advantages of Factoring

Following are advantages of factoring:

  • Factoring cover the risk arising from a potential customers insolvency, the risk being taken over by the factor, while taking into account that the factor does not cover risks arising from commercial or technical disputes.

  • It is provided the treasury supply of the company, the factor paying immediately the claims ceded, after deduction of interest, fee and possibly a collateral deposit created by the factor, elements clearly known when the contract is signed.

  • The factoring companies do not provide new funding, but can accelerate the cash conversion cycle for client companies, enabling them to gain the value from debtor, much faster than if they expected to pass the normal period of trade credit, that means it transforms a sale on term within a cash sales, reducing the short-term indebtedness of the company.

  • The engagement of factor is similar to a trade receivables collection to the delivery of goods without this funding to appear on the liability side. So, the factoring reduces operating cycle length and the need for working capital, helping to improve the company liquidity.

  • Unlike traditional bank loans, factoring doesn’t require you to risk your home or other property as collateral. So there is no collateral required.

  • following the submission of receivables to the factor, the factoring financing enables improving the financial planning for the company of factoring client;

Disadvantages of Factoring

Following are disadvantages of factoring:

  • Relatively high cost due to the multiple services they provide. Factoring costs are usually higher than the costs of the bank loans.

  • The use of factoring gives the impression of a delicate financial situation of the customer company, but this observation is unfounded because factoring companies do not accept, in principle, than the companies with a very good financial situation. Also, factoring is contracted only when a certain factor knows that client is solvent.

  • Client of the factoring may suffer a substantial loss of income, taking into account all fees and risk of loss which is involved.

  • by remission of a portion of the commercial relations to a factoring company, the beneficiary company might also lose some contracts, whether with customers because the factor is more exigent with debtors as regards the compliance of maturities, or banks because the factoring exclude the recourse to banks for mobilization of trade receivables. That means some customers do not want the involvement of third parties

Difference Between Factoring and Bill Discounting

The difference between factoring and bill discounting can be enumerated as below:

  • Factoring is called as ‘invoice factoring’ whereas bills discounting is known as ‘invoice discounting’.

  • In factoring the parties are known as client, factor and debtor whereas in bills discounting they are known as Drawer, Drawee and Payee.

  • Factoring is a sort of management of book debts whereas bills discounting is a sort of borrowing from commercial banks

  • For factoring there is no specific Act, whereas in the case of bills discounting, the Negotiable Instrument Act is applicable.

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