Meaning

Management of cash and receivables is of utmost importance to both corporate giants and small
firms. Many business have collapsed for want of liquidity. The key to success lies in converting
credit sales into cash within a short period of time. Recently, new financial services, such as
factoring and forfaiting, have come into existence to assist the financing of credit sales and,
thereby, help the business unit to tide over the liquidity crunch.

Factoring is a continuing arrangement between a financial intermediary known as the factor

and a business concern (the client) whereby the factor purchases the client’s accounts
receivable/ book debts either with or without recourse to the client. This relation enables the
factor to control the credit extended to the customer and administer the sales ledger.

Besides the purchase of accounts receivables, a factor may provide a wide range of services,
such as the following:

• Credit management and covering the credit risk involved.

• Provision of prepayment of funds against the debts it agreed to buy.

• Arrangement for collection of debts.

• Administration of the sales ledger.

Thus, Factoring is a collection and finance service designed to improve the client’s (seller’s)
cash flow by turning his credit sales invoices into ready cash.

Types of factoring:
• Recourse factoring

In recourse factoring, the factor purchases trade debts and essentially renders collection service
and maintains sales ledgers. But, in case of default or non-payment by a trade debtor, the client
refunds the amount to the factor. Hence, recourse factoring does not include baddebts
protection. It is popular in the developing countries.

• Non-recourse factoring

Under non-recourse factoring, the factor’s obligation to the client becomes absolute on the due
date of the invoice, irrespective of the payment made or not made by the trade debtor. In other
words, if the trade debtor fails to make a payment, the factor cannot recover this amount from
the client. In non-recourse factoring, factor charges are high as they offer the client protection
against bad-debts. The loss arising out of irrecoverable receivables is borne by the factor. This
type of factoring arrangement is found in developed countries such as UK and USA, where
reliable credit rating services are available.
• Advance and maturity factoring

Sometimes, the factor and the client make an arrangement whereby the factor pays a pre-
specified portion of the factored receivables in advance to the client on submission of necessary
documents. This type of arrangement is known as advance factoring. The balance portion is
paid upon collection or on the guaranteed payment date. Generally, factoring is advance
factoring and factor pays 80 per cent of the invoice amount in advance. Under maturity
factoring no advance payment is made by the factor but payment is made only on the
guaranteed payment date or on the date of collection. Maturity factoring is also known as
collection factoring.

• Old line factoring

Old line factoring is also known as full factoring as it provides an entire spectrum of services,
such as collection, credit protection, sales ledger administration, and short-term finance. It
includes all features of non-recourse and advance factoring.

Advantages of factoring

Benefits to the Client

• Quick conversion of credit sales into cash: The client’s credit sales are immediately
converted into ready cash as the factor makes a payment of around 80 per cent of the
factored invoices in advance. This proportion of finance is higher than the bank finance
against credit sales.
• Competitive advantage: The client can offer competitive credit terms to his buyers
which, in turn, enable him to increase his sales and profits.
• Accelerated production cycle: The cash realised from credit sales can be used to
accelerate the production cycle.
• Focus on core activities: The client is free from the tensions of monitoring his sales
ledger and can concentrate on production, marketing, and other aspects. This results in
a reduction in overhead expenses and an increase in sales and profits.
• Working Capital management: Factoring results in a close interaction among working
capital components of the business. Efficient management of one component can have
positive impact on other components. For example, an increase in liquidity enables the
firm to avail of discounts on purchases of raw materials.
 • Monitoring: The factor provides a comprehensive credit control system by analyzing
payment history. This helps in assessing the quality of the debtors and monitoring their
financial health.
• Expansion of business: The client can expand his business by exploring new markets.

Benefits to Customers (Buyers)

• Factoring facilitates the credit purchases of the customers as they get adequate credit period.

• Customers save on bank charges and expenses.

• The customer has not to furnish any documents. He has merely to acknowledge the
notification letter, that is, an undertaking to make payment of the invoices to the factor.
Customers are furnished with periodical statements of outstanding invoices by the factor.

• Factoring does not impinge on the customer’s rights vis-a-vis the supplier’s in respect of the
quality of goods, contractual obligations, and so on.

Benefits to Banks: Factoring improves the liquidity of the clients and, thereby, improves the
quality of advances of banks. Factoring is not a threat to banking; it is a financial service
complementary to that of the banks.
Steps in factoring

o Agreement and Due Diligence: The business (referred to as the "client") enters into an
agreement with a factoring company (the "factor"). The factor conducts due diligence
on the client's customers to assess their creditworthiness. This step helps the factor
determine the risk involved in purchasing the client's invoices.
o Submission of Invoices: Once approved, the client submits its unpaid invoices
(accounts receivable) to the factor for consideration. Invoices should include details
such as the invoice amount, due date, customer information, and products/services
provided.
o Verification and Approval: The factor verifies the authenticity of the submitted invoices
and cross-checks them with the client's records and the customers' records. If everything
is in order, the factor approves the invoices for funding.
o Funding and Advance: The factor provides the client with an advance payment,
typically a percentage of the total invoice value (e.g., 70-90%). The advance amount
depends on factors such as the creditworthiness of the customers and the industry.
o Invoice Collection: The factor takes over the responsibility of collecting payments from
the client's customers. The customers are informed of the new payment instructions and
are directed to pay the factor directly.
o Customer Payment: The customers make payments to the factor on or before the invoice
due date. The factor deposits the payments received into a dedicated account.
o Reserve and Settlement: After collecting the full payment from the customers, the factor
deducts its fees (including discount fees and other charges) and holds a reserve amount.
The reserve is typically a percentage of the total invoice value and acts as a safeguard
against potential customer defaults.
o Final Payment: Once the reserve is determined and any outstanding invoices are settled,
the factor pays the remaining balance (reserve amount) to the client.
o Reporting and Record Keeping: The factor provides regular reports to the client
detailing the status of invoices, collections, and reserves. The client maintains records
of the factoring transactions for accounting and reconciliation purposes.

Functions of a factor

1. Maintenance of Sales Ledger:

A factor maintains sales ledger for his client firm. An invoice is sent by the client to the
customer, a copy of which is marked to the factor. The client need not maintain individual sales
ledgers for his customers. On the basis of the sales ledger, the factor reports to the client about
the current status of his receivables, as also receipt of payments from the customers and as part
of a package, may generate other useful information. With the help of these reports, the client
firm can review its credit and collection policies more effectively.

2. Collection of Accounts Receivables:

Under factoring arrangement, a factor undertakes the responsibility of collecting the

receivables for his client. Thus, the client firm is relieved of the rigours of collecting debts and
is thereby enabled to concentrate on improving the purchase, production, marketing and other
managerial aspects of the business. With the help of trained manpower backed by
infrastructural facilities a factor systematically undertakes follow up measure and makes timely
demand in the debtors to pay amounts. Normally, debtors are more responsive to demands or
reminders from a factor as they would not like to go down in the esteem of credit institution as
a factor.

3. Credit Control and Credit Protection:

Another useful service rendered by a factor is credit control and protection. As a factor
maintains extensive information records (generally computerized) about the financial standing
and credit rating of individual customers and their track record of payments, he is able to advise
its client on whether to extend credit to a buyer or not and if it is to be extended the amount of
the credit and the period there-for.

4. Advisory Functions:

At times, factors render certain advisory services to their clients. Thus, as a credit specialist a
factor undertakes comprehensive studies of economic conditions and trends and thus is in a
position to advise its clients of impending developments in their respective industries.

For Advanced learners

Difference between Bills Discounting and Factoring

➢ Bills discounting is an individual transaction in the sense that each bill is separately
assessed and discounted. Factoring is a financial service provided by a financial
institution/intermediary on a whole turnover basis. Factoring is the provision of bulk
 finance against several unpaid trade invoices. This gives the client the liberty to draw
desired finance only.
➢ In case of bills discounting, each bill has to be individually accepted by the drawee,
which takes time. In factoring a one-time notification is taken from the customer at the
commencement of the facility.
➢ Bills discounting is an expensive short-term source of finance as stamp duty is charged
on certain usance bills together with bank charges. In case of factoring, no stamp duty
is charged on the invoices and hence it is less expensive than bills discounting.
➢ Bills discounting involves more paper work as compared to factoring.
➢ In case of bills discounting, the grace period for payment is usually three days while in
case of factoring, the grace period is higher.
➢ Bills discounting requires submission of original documents such as bill of lading,
challans, and invoices. Only copies of such documents are required in factoring.
➢ In bills discounting, charges are normally upfront whereas there are no upfront charges
in case of factoring. Finance charges are levied on the amount of money withdrawn.
➢ Bills discounting is not an off-balance sheet mode of financing while factoring is.
➢ Bills discounting is more domestic-related and usually falls within the working limits
set by the bank for the customer. Factoring may be domestic or international and is not
concerned with the working capital limits set by the bank.
➢ Bills discounting does not involve the assignment of debts while factoring involves
assignment of debts.