What is factoring?
Factoring is a financial option for the management of receivables. In simple definition 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% (rarely up to 90%) of the amount immediately on agreement. Factoring company pays the remaining amount (Balance 20% minus finance cost minus 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 in construction services (in government contracts it is assured that the government body can pay back the debt in the stipulated period of factoring and hence contractors can submit the invoices to get cash instantly), factoring against medical insurance etc. Let us see how factoring is done against an invoice of goods purchased.
Characteristics of factoring
Usually the period for factoring is 90 to 150 days. Some factoring companies allow even more than 150 days.
Factoring is considered to be a costly source of finance compared to other sources of short term borrowings.
Factoring receivables is an ideal financial solution for new and emerging firms without strong financials. This is because credit worthiness is evaluated based on the financial strength of the customer (debtor). Hence these companies can leverage on the financial strength of their customers.
Bad debts will not be considered for factoring.
Credit rating is not mandatory. But the factoring companies usually carry out credit risk analysis before entering into the agreement.
Factoring is a method of off balance sheet financing.
Cost of factoring=finance cost + operating cost. Factoring cost vary according to the transaction size, financial strength of the customer etc. The cost of factoring vary from 1.5% to 3% per month depending upon the financial strength of the client’s customer.
For delayed payments beyond the approved credit period, penal charge of around 1-2% per month over and above the normal cost is charged (it varies like 1% for the first month and 2% afterwards).
Different types of Factoring
Disclosed and Undisclosed
Recourse and Non recourse
A single factoring company may not offer all these services.
In disclosed factoring client’s customers are notified of the factoring agreement. Disclosed type can either be recourse or non recourse.
In undisclosed factoring, client’s customers are not notified of the factoring arrangement. Sales ledger administration and collection of debts are undertaken by the client himself. Client has to pay the amount to the factor irrespective of whether 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.
In recourse factoring, client undertakes to collect the debts from the customer. If the customer don’t pay the amount on maturity, factor will recover the amount from the client. This is the most common type of factoring. Recourse factoring is offered at a lower interest rate since the risk by the factor is low. Balance amount is paid to client when the customer pays the factor.
Non recourse factoring
In non recourse factoring, factor undertakes to collect the debts from the customer. Balance amount is paid to 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 organization.
Factoring companies in India
A study on Factoring services in India(PDF)
Click here to read the article about factoring in India and role of reserve bank, role of factoring in Indian SMEs, challenges faced by factoring sector and role of factoring in India as an emerging market (pezzottaitejournals.net)
What are the problems faced by factoring industry in India
Click here to read the article about the status of factoring industry in India and the challenges ahead.
Growth of Factoring Services in India
Click here to read the article about the growth of factoring services in India – An analysis of the current scenario.