The factoring’ is derived from Latin ‘factor’ ‘factor’ which means ‘doer’. The Webster’s New Collegiate inc. nary defines a factor as “one that lends money to producers and dealers on the security of accounts receivables. Factoring is an arrangement between a business and a third party (factor) whereby the debtors f the business is transferred to the factor at a certain discount in the immediate exchange of the money. Thus, factoring can be termed as a means to finance.
Definition of Factoring
According to C.S. Kalyanasundaram, “Factoring is outright. purchase of credit approved account receivables with the factor assuming bad debt losses .”
According to Aim Calpin, -Factoring is a system designated to eliminate payment risk in overseas sales and ensure that the seller receives prompt settlements.”
Thus, a factor is a financial institution that advances money to the business and undertakes its debtors along with the risks associated with the collection of the debts.
Under this arrangement, the business transfers all the losses and the collection charges associated with the of the debts to the factor, and the factor in return charges some discount or commission on the collection. There are three parties involved in factoring:
1) The factor,
2) The client (seller), and
3) The customer (buyer).
This agreement is normally for a period of one year and can be renewed further. On the other hand, it can also be canceled at any time before the expiry of the term with proper intimation.
Types of Factoring
The various types of factoring are as follows:
1) Recourse Factoring: Under this arrangement of factoring, the factor acts as a mere collection agent for the client. The trade debts are handed over to the factor and he prepares the sales ledger. ledger. In case of any bad debts arising, the amount of loss is reimbursed by the client. Thus, it can be said that the bad debts are not covered under this mode of factoring and this is most popular in the developing economies.
2) Non-Recourse Factoring: Under this type of factoring, factors obligation towards the client starts from the date of the sale and the amount of bad debt loss is also covered. i.e. if the debtor is unable to repay the debt, the loss will be borne by the factor and not the client. Thus in this form of factors, the liability is high and to cover this high discount rates and commission is implied. This method is suitable where the credit rating services are reliable as in U.K. and U.S.A.
3) Advance Factoring: A certain pre-decided amount between 75%-90% is initially advanced by the factor to the client and the remaining to be paid on the collection date. This money is advanced as soon as the debts are approved and the invoices are issued. In lieu of this amount, the client is to pay the interest in the form of the discount charges for the period the amount is received and the actual collection is made by the factor. These discount/interest rates are decided in advance at the time of entering into an agreement after considering the financial health of the client and the sale turnover.
4) Bank Participation Factoring: The next level of advance factoring is bank participation. Under this method, the bank also finances 50% of the factor reserve, i.e., the amount that is kept in reserve by the factor. For example, in debt of 100, let’s say SO% is financed by the factor. So, for the balance 20, 50% is financed by the bank. In a way, the client is actually getting 90% finance and the amount of investment in the receivables is just 10%.
5) Maturing Factoring: The maturing factoring is also termed as Collection Factoring. Under this type of arrangement, no pre-payment is made to the client rather the same is either made on the pre-decided date or the date on which the collections are made. The dates are pre-decided by the factor on the basis of the past experience with the client and the quality and quantity of the balances in the receivables.
6) Notified and Undisclosed Factoring: Under notified or disclosed factoring, the customer is made known the fact of factoring and is instructed to pay the sum due to the factor instead of the company. While in the case of undisclosed factoring, the same fact remains hidden from the customer and he is to oblige his debts only to a changed address. The factor and the company are just treated as the same person for the customer. This is also termed as the non-notified factoring or confidential factoring.
7) Full Factoring: It combines the features of both the non-recourse and advance factoring. It is also termed as Old Line Factoring. Under this type of factoring all services like collection, credit protection, sales ledger monitoring, short-term financing are covered, making it as a most comprehensive form of factoring.
8) Invoice Factoring: In the present environment, this type of factoring does not exist. The reason behind that is the service element of factoring is not considered. Under this type, the factor purchases the debts of the client providing him with enough liquidity to carry on the operations smoothly.
9) Buyer-Based, Seller-Based, and Selective Factoring: Under this, a separate list is prepared by the factor containing the details of the buyers whose receivables would be factored without recourse to the seller. Whereas under seller based factoring the phenomenon is reversed. It is also termed as selective factoring as it imposes a restriction on the seller and he is to only sell to the approved customers.
10) Export Factoring: This is also termed as international factoring or cross-border factoring. The export houses provide various sales-related services like financial, collection, advisory, legal and other allied services besides the usual factoring services. This type of factoring is quite useful for small export houses and new start-ups in export.
Working/Mechanism of Factoring
Credit sales form the base for the concept of factoring, as the main purpose of factoring is to realize the debts arising out of the credit sale. As soon as a credit transaction takes place, the key role of the factor to realize the debts starts. The factor is as an intermediary between the company and its customers and its main task is of a collection agency. Upon realization of the debt, the same is paid to the company after deduction of a fee, commission or discount as decided thereupon in the agreement.
The concept of factoring is illustrated
- The credit sale of the goods and the services take place.
- Debtors are assigned to the factor.
- About 80% of the money is advanced by the factor and he also sends collection statements periodically.
- The factor sends a copy of the accounts to the customers.
- The collection is done by the customer.
- Balance 20 % is paid to the client only after the final collection and after deducting the factoring charges.