Fair Coy Of Factoring 2003

INTRODUCTION Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm’s credit worthiness. Secondly, factoring is not a loan – it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three. It is different from the forfeiting in the sense that forfeiting is a transaction based operation while factoring is a firm-based operation meaning, in factoring, a firm sells all its receivables while in forfeiting, the firm sells one of its transactions. Factoring is a word often misused synonymously with invoice discounting . Factoring is the sale of receivables whereas invoice discounting is borrowing where the receivable is used as collateral. The three parties directly involved are: the one who sells the receivable, the debtor, and the factor. The receivable is essentially a financial asset associated with the debtor’s liability to pay money owed to the seller (usually for work performed or goods sold). The seller then sells one or more of its invoices (the receivables) at a discount to the third party, the specialized financial organization to obtain cash. The sale of the receivables essentially transfers ownership of the receivables to the factor, indicating the factor obtains all of the rights and risks associated with the receivables. Accordingly, the factor obtains the right to receive the payments made by the debtor for the invoice amount and must bear the loss if the debtor does not pay the invoice amount. Usually, the account debtor is notified of the sale of the receivable, and the factor bills the debtor and makes all collections. Critical to the factoring transaction, the seller should never collect the payments made by the account debtor; otherwise the seller could potentially risk further advances from the factor.

There are three principal parts to the factoring transaction; a.) the advance, a percentage of the invoice face value that is paid to the seller upon submission, b.) he reserve, the remainder of the total invoice amount held until the payment by the account debtor is made and c) he fee, the cost associated with the transaction which is deducted from the reserve prior to it being paid back the seller. Sometimes the factor charges the seller a service charge, as well as interest based on how long the factor must wait to receive payments from the debtor. The factor also estimates the amount that may not be collected due to nonpayment, and makes accommodation for this when determining the amount that will be given to the seller. The factor's overall profit is the difference between the price it paid for the invoice and the money received from the debtor, less the amount lost due to non-payment.

DEFINITION

“Factoring is a service involving the purchase by a financial organization, called a factor, of receivables owned to manufacturer and distributors by their customers, with the factor assuming full credit and collection responsibilities.” “Factoring is a service of financial nature involving the conversion of credit bills into 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 other sources of short term borrowings. 3. 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. 4. Bad debts will not be considered for factoring. 5. Credit rating is not mandatory. But the factoring companies usually carry out credit 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 to the transaction size, financial strength of the customer etc. The cost of factoring varies from 1.5% to 3% per month depending upon the financial strength of the client's customer. 8. Indian firms offer factoring for invoices as low as 1000Rs 9. 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)

BENEFITS OF FACTORING There are multifarious reasons to go for factoring. Some of them are quite obvious, where as others are more subtle. A few of the benefits of factoring are listed below:

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Factoring is easy and fast Turn accounts receivable into cash immediately Avoid giving up equity to raise cash Meet increasing sales demands Offer better credit terms to customers Take advantage of early payment discounts using cash freed by factoring Concentrate on core functions like marketing and production Stop offering early payment discounts to customers Improve your credit worthiness by meeting obligations on time Don't incur any new debt Use your customer's good credit as leverage Get invoices paid faster Reduce your company’s bad debt Early detection and warning of customer service problems Credit screening Credit monitoring No geographical limits Receive professional collections and invoice processing assistance

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Receive detailed management reports

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Different types of Factoring 1. Disclosed and Undisclosed 2. Recourse and Non recourse A single factoring company may not offer all these services. Disclosed In disclosed factoring client's customers are notified of the factoring agreement. Disclosed type can either be recourse or non recourse. Undisclosed 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. Recourse factoring 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 SERVICES IN INDIA Though factoring services have been introduced since 1991 in India still it is quite new in the sense that factoring product is not widely known in many parts of the country. Recognizing the utility of factoring services for small and medium size industrial and commercial enterprises in India, for the first time the Vaghul Committee which submitted its report on the Money Market, recommended the development of a system of factoring of open account sales particularly for the small scale industrial units. This committee further observed that both banks and non-bank financial institutions in the private sector should be encouraged to set up institutions for providing factoring services. Later, the Kalyanasundaram Committee, which was appointed by the Reserve Bank of India (RBI) in 1988 specifically for exploring the possibilities of launching factoring services in India, found an abundant scope for such services and hence strongly advocated for the introduction of factoring services in India. This committee also observed that banks were ideally suited for providing factoring services to the industries in the economy. However, the said Committee expressed the view that to begin with only four or five banks either individually or jointly should be allowed on zonal basis to undertake factoring services. The recommendations of Kalyanasundaram Committee were accepted by the RBI. Subsequently a suitable amendment was made in the Banking Regulation Act 1949, so as to allow banks to set up subsidiary company for undertaking factoring services. To begin with, the RBI permitted both the State Bank of India and Canara Bank to start factoring services through their own subsidiaries. Accordingly, two

factoring companies in India, i.e. SBI Factors and Commercial Services Ltd. and Canbank Factors Ltd; sponsored by the State Bank of India and Canara Bank respectively, commenced operations in 1991. In the beginning they were allowed to operate in Western and Southern Zone of India respectively. However, later on, the RBI lifted these area restrictions on their operations and accordingly, both these companies were given permission to expand and operate their business in other parts of the country. In view of this, they can operate on all-India basis. In 1993 the RBI allowed all the scheduled commercial banks to introduce factoring services either departmentally or through a subsidiary set-up. Besides SBI Factors and Commercial Services and Canara bank Factors Ltd., there are a few non-banking finance companies such as Formost Factors Ltd., Global Trade Finance Pvt. Ltd. (a subsidiary of EXIM Bank) and Integrated Financial Services Ltd., which are also in the business of domestic factoring in India. Of these, Global Trade Finance Pvt. Ltd. and Formost Factors Ltd. have undertaken the business of export factoring also. Besides

these

non-banking

finance

companies,

Small

Industries

Development Bank of India (SIDBI), Hongkong and Shanghai Banking Corporation have been offering factoring services to their clients. Almost all of them have been providing factoring services to the SSI and non-SSI units.

Changing scenario business in India :

of

Factoring

 S B I F a c t o r s p u r c h a s e s t h e 9 1 % s t a k e i n G l o ba l T r a d e F i n a n c e t o g a i n a m a r k e t s h a r e o f a r ou n d 7 5 % i n f a ct o r i n g b u s i n e s s b y a p r i l 2 0 0 8 . 

HSBC is going to provide factoring business for SME’s

 S p e c i a l l y i n M u m b a i , N e w D e l h i , K o l k a t a , Pu n e , B a n ga l o r e a n d C h en n a i . S M E w i t h t u r n ov e r o f m o r e t h a n 5 crore can avail the facility of factoring from HSBC . 

H S B C t i e s u p w i t h N e w I n d i a A s s u ra n c e f o r c r e d i t r i s k insurance.



With the increasing demand for factoring services, f o r e i g n p l a y e r s s u ch a s D e v e l o p m e n t B a n k o f S i n g a p o r e ( D B S ) a n d G E C a p i t a l h a v e s h o wn t h e i r k e e n i n t e r s t t o g e t t i n g i n t o t h e f a c t o r i n g b u s i n e s s i n I n di a . B o t h D B S and GE Capital have global exposure in the factoring business.



M a n y g l o b a l p la y e r s i n t h e f i e l d o f b a n k i n g ( S t a n da r d C h a r t e r e d B a n k , C i t i Ba n k , e t c ) a r e c o m i n g f o r w a r d t o I n d i a t o c a r r y o n f a ct o r i n g bu s i n e s s i n S M E s e g m e n t since the scope for financing large corporates is r e a c h i n g s a t u r a t i o n p o i n t . S M E s e ct o r p l a ys a m a j o r role in India’s present export performance, c o n t r i b u t i n g t o 4 5 - 5 0 % of t h e I n d i a n e x p o r t s . G l o ba l Trade Finance has dedicated most of its facilities to t h e S M E s e ct o r .



With the growth of factoring business ,credit i n s u r a n c e i s a ls o g e t t i n g e d g e d a y b y d a y t o da y s p e c i a l l y f o r t h e g l o b a l f a c t o r s wh o a r e o p e r a t i n g i n India.

 A c c o r d i n g t o F a c t o r s C h a i n I n t e r n a t i on a l , t h e o b s e r v e r of all factoring companies, India with just eight c o m p a n i e s c l o c k e d a t ot a l t u rn o v e r o f R s 1 9 , 8 6 0 . 5 c r o r e i n 2 0 0 6 wa y b e l o w J a p a n ’ s R s 4 , 1 5 , 7 8 9 . 1 c r o r e Taiwan’s Rs 2,23,152. 6 crore and China’s Rs 7,97,77.1

c r o r e i n A s i a . Th e I n d i a n f a c t o r i n g ma r k e t h a s g r o w n b y 176 per cent from Rs 7,196.7 crore to Rs 19,860.5 crore between 2002 and 2006. Global leaders are the UK, France and Italy.

EXPORT-FACTORING IN INDIA: AN OVERVIEW

Factoring is a fund-based facility. RBI as a measure to solve the problem of the working capital of the suppliers extended the factoring as the new form of the financial services in India. It was set up after the recommendation of the Kalyanasundaram Committee in 1988. They initially developed the concept of the inland Factoring, but later on Export Financing become one of their emphasized areas.

In Factoring, a financial institution (factor) buys the accounts receivables of a company (Client) and pays up to 80% (and on rare cases up to 90%) of the amount immediately on agreement, and remaining amount i.e. 20% or 10% when the customer pays the debt. Collection of the debt depends either on the factor or client depending upon the type of the agreement. Usually the period of factoring is 90 to 150 days. Some factoring companies allow even more than 150 days, depending upon the type of agreement or the relation between the factor and the client. The factoring cost varies from 1.5% to 3% per month, according to the transaction size, financial strength of the customer etc. The factoring in India can be done for invoices as low as 1000Rs.

Considering the growth of the International markets and globalization there was the need to lay emphasis on the Export factoring. In the international trade it is customary to use two-factor system, i.e. system constituting the Export factor and Import factor. Under this arrangement, • Exporter sells goods on open credit. • Export receivables are factored to the factor on the non-recourse basis (generally). All the supporting documents relating to the export transaction are given to the export factor. • Export factor performs its function of credit collection, sales ledger accounting and collection to the import factor with respect to the customers located in the importing country.

• Import factor collects the money due from the customers concerned. • Import factor effects the payments to the export factor on assignment or maturity or collection or as per the agreement. • Export factor makes payment to the exporter upon assignment or maturity or collection or as per the agreement. Advantage over the other Export Financial Services: Factoring is still at the growing stage in India, though gaining popularity but it has been compared to the long followed financial service of Bill Discounting, though they both make finance available to the exporter against the accounts receivables held by the client. There are a few advantages that the factoring enjoys over bill discounting. • Factoring involves a pre-payment against all unpaid and not-due invoices purchased by the factor, where as in bill discounting, each bill is separately assessed and discounted by the financial intermediary. • Factoring involves other facilities also like collection of debts and sales ledger administration and advisory, whereas these facilities are unavailable in a bill discounting arrangement. • Factoring can be a non-recourse type of an arrangement while bill discounting is usually a recourse type of an arrangement. Export-Factoring Companies in India: Introduction of export factoring in India will certainly provide an additional window of facility to the exporters. Further, the position of realization of export proceeds of shipment made by the Indian exporters is sufficiently encouraging for the interested organizations to offer factoring services to exporters from India. There are many companies offering export-factoring services, a few like: • SBI Factors and Commercial Services Pvt. Ltd.: SBI Factors, a subsidiary of State Bank Of India, is one of the leading factoring companies in India with an asset base of

Rs.919.36 crores as on March 31, 2006. It is the first factoring company to be set up in India. It was incorporated in February 1991 and commenced business operations from April 1991. State Bank of India and its 2 associate banks have a 70% stake in SBI Factors while 20% is held by Small Industries Development Bank Of India (SIDBI) and 10% by Union bank of India. As on March 31, 2006, it has a market share of approximately 40% in the factoring business. • Global Trade Finance Limited (GTF): Global Trade Finance Limited (GTF) is the only provider of international factoring, domestic factoring and forfaiting services under one roof in India. GTF is headquartered in Mumbai. GTF commenced its operations in September 2001, as a joint venture between WestLB, Germany (40%), ExportImport Bank of India (35%) and International Finance Corporation, Washington (25%), which is the private sector arm of the World Bank. Effective December 24, 2004, GTF's shareholding is now 40% with Export-Import Bank of India, 38.5% with FIM Bank, Malta, 12.5% with IFC, Washington and 9% with Bank of Maharashtra.GTF is a member of Factors Chain International, a global association of international factoring companies Established in 1968, FCI has played a major role in bringing factoring into most countries and today has a membership of 211 factoring companies operating in 61 countries.

Factoring and its Significance in Indian Economy: With the advent of globalization and opening up of Indian economy, Export Factoring will play a crucial role in

encouraging the international trade. It has gained popularity among the international traders due to the diverse services provided by it. The major boost to the economy in the future will be through the advice or suggestions given to the various traders that will facilitate them to perform better. Factoring will also promote a prompt payment culture among industrial and trading units by facilitating the overall acceleration of the receivables turnover. The impact of this accelerated receivables turnover will be better return on capital because of the facilitation of greater volume of business on the same amount of capital or the same amount of business on smaller amount of capital. Thus, such a prompt payment culture prompted by factoring among industrial land trading units and the resultant overall accelerated receivables turnover will ultimately have a multiplier effect on production, employment and economic growth.

International Factoring In international factoring there are usually two factors. The export factor looks at financing the exporter and sales administration (presenting invoices at the right time, collecting payments being the key tasks). The

import factor is interested in evaluating the buyer, collecting the money on time at the same time ensuring that he is protected against default. International factoring encompasses all the four services, that is, prepayments, sales ledger administration, credit protection and collections.

7 - Step Guide to International Factoring: 1. The importer places the order for purchase of goods with the exporter. 2. The exporter requests the Export Factor for limit approval on the importer. Export Factor in 3. Turn forwards this request to an Import Factor in the Importer's country. The Import Factor 4. Evaluates the Importer and conveys its approval to the Export Factor who in turn conveys 5. Commencement of the Factoring arrangement to the Exporter. 6. The exporter delivers the goods to the importer.

7. Exporter produces the documents to the Export Factor. 8. The Export Factor disburses funds to the Exporter upto the prepayment amount decided and at the 9. Same time the forwards the documents to the Import factor and the Importer. 10. On the due date of the invoice, the Importer pays the Import Factor, who in turn remits this 11. Payment to the Export Factor. 12. The Export Factor applies the received funds to the outstanding amount of the advance against 13. The invoice. The exporter receives the balance payment.

Factoring in India A factor provides finance to his client upto a certain percentage of the unpaid invoices which represent the sales of goods or services to

approved customers. The mechanism of the factoring scheme is as follows:  There should be a factoring arrangement (invoice purchasing arrangement) between the client(which sells the goods and services to trade customer in credit) and the factor, which is the financing organization.  Whenever the client sells goods to the trade customers on credit he prepares invoices in the usual way.  The goods are sent to the buyers without raising a bill of exchange but accompanied by an invoice.  The debt due by the purchaser to the client is assigned to the factor by advising the trade customers to pay the amount due to the client, to the factor.  The client hands over the invoices to the factor under cover of a schedule of offer along with the copies of invoices and receipted delivery challans.  The factor makes an immediate payment upto 80% of the assigned invoices and the balance 20% will be paid on realization of the debt.

Let us see how factoring is done against an invoice of goods purchased.

Customer

credit sale of goods

Client

Invoic e

Pays the balance amount

Pays the amount (In recourse type customer pays through client)

Submit invoice copy

Payment up to 80% initially

Factor

Risks The most important risks of a factoring are:

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•

• • • • •

Counter party credit risk related to clients and risk covered debtors. Risk covered debtors can be reinsured, which limit the risks of a factor. Trade receivables are a fairly low risk asset due to their short duration. External fraud by clients: fake invoicing, mis-directed payments, pre-invoicing, not assigned credit notes, etc. A fraud insurance policy and subjecting the client to audit could limit the risks. Legal, compliance and tax risks: large number of applicable laws and regulations in different countries. Operational risks, such as contractual disputes. Uniform Commercial Code (UCC-1) securing rights to assets. IRS liens associated with payroll taxes etc. ICT risks: complicated, integrated factoring system, extensive data exchange with client.

CONCLUSION  Factoring is a money market instrument.

 Since, factoring is not a negotiable instrument, customer’s consent is required about the factoring arrangement under which he will make a repayment directly to the factor but not to the client.  As a result of factoring services, the enterprise can concentrate on manufacturing and selling.  The risk of bad debts is eliminated.  The factoring institution also provides advice on business trends and other related matters.