Factoring is a process of transaction, where the accounts receivables or invoice of a business is sold to a third party at discount. The third parties involved are called factor (specialized financial organization), customer or account debtor. In order to obtain cash, the seller of a company sells its accounts receivables to factor at a discount, which is called advance factoring. Obtaining approval for factoring the account receivables, is not based on the credit ratings of the company but the financial credentials of the company is important. Here are some of the basic terms that are involved in this process.
- Invoice: It is a commercial document issued to a buyer by a seller that indicates the payment terms, price of the product, services provided and quantity of the product.
- Accounts Receivable: It is the amount of cash owned by the customers to a business, as assets. It is also known as debtors, and this amount is indicated in the balance sheet of the business.
- The client sends invoice or goods to customer on credit basis.
- The client assigns invoice to the factor.
- The factor makes a pre-payment to the client, which is up to 80% of the assigned price.
- The factor sends the account statement to the customer.
- The customer sends money in payment which is due to the factor.
- After receiving the payment from the customer, the factor pays the balance 20% to the client.
If the customer is not able to make the payment, the factor recourses to the client if the debt becomes irrecoverable. The client may refund the amount that was previously paid by the factor. The factor becomes entitled to recover the due amount, if the customer commits a default. The factor may charge the client for the services provided to the client by factor such as maintaining sales ledger, collecting customer's debt, etc.
The factor cannot recourse to the client in case of his financial inability to pay the due. The loss due to the irrecoverable receivables should be endured by the factor and the factor's obligation becomes absolute on the due payment date. The factor charges del credere commission for the loss and also participates in the process of grant of credit and extension of line of credit to the customers. This type is common in developed countries such as U.S., U.K., etc.
Advance and Maturity Factoring
The factor pays an advance payment in the range of 70% to 80%, to the client, and get an approval from the client, that the balance amount will be paid back, once the amount is received from the customer. The interest for the advance payment paid by the factor, is also collected from the client, by the factor, considering the short-term rate, financial standing of the client, turnover etc.
This type is also called full factoring, as it provides all kinds of services such as credit protection, short-term finance, etc. This combines the features of both non-recourse and advance factoring.
When the transaction is related to domestic sales, it is called domestic factoring. It is further divided into:
The client or the buyer bears the total risk of non-payment of the factor. The factor need not bear the risk of bad debt due to the payment failure of the customers. This is a form of recourse factoring.
The name of the factor involved in the dealing between the customer and the client is not disclosed in the invoice document. In this type, the customer will be at risk due to bad debt, and the customer is required to arrange for the payments and send it to the client. This type is also known as confidential or non-notified factoring.
In this type, the factor discounts the invoices present in the bill which is provided by the seller, at a pre-agreed credit limit, with the help of financial institutions. It is also called service plus finance factoring.
Bank Participation Factoring
With the help of a banker, the factor arranges a part of the money that should be paid to the client. The net factor advance is calculated as a product of factor advance percent and bank advance percent.
This provides credit protection against customers who are unable to pay the due amount to the client. The factor pays the amount mentioned in the invoice, either on the guaranteed date or on the date of collection (after due date mentioned in invoice).
This type is also known as export factoring or international factoring. There are four parties involved in this process. They are client (exporter), customer (importer), export factor and import factor. The import factor resolves all the international trade barrier formalities and acts as a link between the customer and the export factor.
The client is more profited because, the factor helps him to improve the liquidity of his company. This process is not present in today's factoring system because of the absence of the element 'factoring'.
Capital management is made efficient due to this process and this helps to enhance the liquidity of the firm. The scope of the operating leverage is also improved. There is a new concept that utilizes the strengths of factoring, which is called reverse factoring or supply chain finance. Through this process, security and interest rate is improved, benefiting the buyer and the supplier respectively. However, various legal issues are involved in the process of factoring.