What Is Factoring

ASSIGNMENT OF FACTORING SUBMITTED TO:Prof... Dhiraj Sharma

SUBMITTED By:Jagjeet Singh Jatinder Garg MBA 3rd (A)

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%-finance costoperating 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 for construction services (usually for government contracts where the government body is capable of paying back the debt in the stipulated period of factoring. Contractors submit invoices to get cash instantly), factoring against medical insurance etc. Let us see how factoring is done against an invoice of goods purchased.

Flow Chart of Factoring

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

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. Credit rating is not mandatory. But the factoring companies usually carry out credit risk analysis before entering into the agreement.

5. 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.

6. Indian firms offer factoring for invoices as low as 1000Rs 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

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 companies in India Canbank Factors Limited: http://www.canbankfactors.com

SBI Factors and Commercial Services Pvt. Ltd: http://www.sbifactors.com The Hongkong and Shanghai Banking Corporation Ltd: http://www.hsbc.co.in/in/corp/factserv.htm Foremost Factors Limited: http://www.foremostfactors.net Global Trade Finance Limited: http://www.gtfindia.com Export Credit Guarantee Corporation of India Ltd: http://www.ecgcindia.com Citibank NA, India: http://www.citibank.co.in Small Industries Development Bank of India (SIDBI): http://www.sidbi.in/fac.asp

Domestic Factoring & International Factoring

Factoring is a service that covers the financing and collection of account receivables in domestic and international trade. It is an ongoing arrangement between the client and Factor, where invoices raised on open account sales of goods and services are regularly assigned to "the Factor" for financing, collection and sales ledger administration. The buyer and the seller usually have long term relationships. The client sells invoiced receivables at a discount to the factor to raise finance for working capital requirement. The factor may or may not accept the incumbent credit risk. Factoring enables companies to sell their outstanding book debts for cash.

The factor operates by buying from the selling company their invoiced debts. These are purchased, usually with credit protection, by the factor who then will be responsible for all credit control, collection and sales accounting work. Thus the management of the

company may concentrate on production and sales and need not concern itself with non-profitable control and sales accounting

matters. By obtaining payment of the invoices immediately from the factor, usually up to 80% of their value the company's cash flow is improved. The factor charges service fees that vary with interest rates in force in the money market.

The world's local bank

Trade & Factoring Services

HSBC currently offers both domestic and international factoring products. HSBC provides finance solutions for all your sales and purchase requirements on the domestic front, and various export-factoring product services on the international level. Our factoring services offer a comprehensive receivables and payables management solution which includes transaction financing, credit protection, sales ledger administration and payment collection. At HSBC, our ability to be the comprehensive provider of Trade Solutions makes us a leading player in the Trade & Factoring market in India. We have dedicated Relationship Managers to provide any assistance that you may require with respect to your business and your trade needs.

Domestic Factoring Through this product, our intention is to be an active partner in the management of your company's supply/delivery chain. Through domestic factoring, we could look at financing your receivables from your buyers. Additionally we also undertake to finance your vendor/supplier payments. Receivables Finance can be structured with on a With Recourse Basis (where we would be setting up lines on your company) or on a Without Recourse Basis. Payments of all your service and utility bills could be done through our Vendor Finance product. These could include for example, courier payments, electricity bills payment.

Through this mechanism we will pay out your service provider on the due date of the invoice/bill and collect the money from you after a pre-determined credit period.

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, pre-payments, sales ledger administration, credit protection and collections.

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.

Function of a factor 1. Administration of sales ledger The factor maintain sales ledger in respect of each client when the sales transaction takes place an invoice is prepared in duplicate by the client, One copy is given to customer and second copy is sent to the factor. Entries are made in the ledger on open item method. Each recipt is matched against the specific invoice.On any given date the customer account indicate the various open invoices outstanding .Periodec reports are sent by factor to the clint with respect to current status of transaction,the periodicity of report is decided. Thus the entire sales ledger administration responsibility of the client gets transferred to factor.

2. Collection of Recivables The main function of the factor is to collect the receivable on the behalf of the client and to relieve him from all the botherations problems associated with the collection . This way the clint can concentrate on

other major areas of his business on one hand and reduce the cost of collection by way of saving in labour time and efforts on the other hand. The factor possesses trained and experienced personal, sophisticated infrastructure and improve technology which helps him to make timely demands on the debtors to make payments.

3. Provision of Finance Finance which is the life blood of a business, is made available easily by the factor to the client. A factor purchased the book debts of his client and debts are assigned in favour of the factor .75%to 80% of the assigned debts is given as advance to the client by the factor.

4. Protection Against Risk This sevices is provided where the debts are factored without resources. The factor fixes the credit limit in respect of approved customers. Within this limit the factor undertakes to purchase all trade debts and assumes risk of default in payment by the customers. The factor not only relives the client from the collection work but also advises the client on the creditworthiness of potential customers . Thus the factor helps the client in adopting better credit control policy. The credit standing of the

customers is assessed by the factors on the basis of information collected from credit rating reports, bank reports, trade reference, financial statement analysis and by calculating the important ratios in respect of liquidity and probility position.

5. Advisory Services These services arise out of theclose relationship between a factor and a client. Since the factor have better knowledge and wide experience in field of finance, and possess extensive credit information about customers standing they provide various advisory services on the matters relating to:

I. Customer’s preferences regarding the clients products. II. Changes in marketing polices of the competitors. III. Suggest improvements in the procedures adopted for invoicing, delivery and sales return. IV. Helping the clients for raising finance from banks /financial institutions, etc.

Discount Rate In the beginning, the factoring industry had some relatively high discount rates due to heavy expenses caused by costly litigation battles and limited access to traditional investors. However, once state and federal legislation was enacted, the industry’s interest rates decreased dramatically. There is much confusion with the terminology “discount rate” because the term is used in different ways. The discount rate referred to in a factoring transaction is similar to an interest rate associated with home loans, credit cards and car loans where the interest rate is applied to the payment stream itself. In a factoring transaction, the factoring company knows the payment stream they are going to purchase and applies an interest rate to the payment stream itself and solves for the funding amount, as though it was a loan. Discount rates from factoring companies to consumers can range anywhere between under 9% up to over 18% but usually average somewhere in the middle. Factoring discount rates can be a bit higher when compared to home loan interest rates, due to the fact the factoring transactions are more of a boutique product for investors opposed to the mainstream collateralized mortgage transactions. One common mistake in calculating the discount rate

is to use “elementary school math” where you take the funding/loan amount and divide it by the total price of all the payments being purchased. Because this method disregards the concept of time (and the time value of money), the resulting percentage is useless. For example, the court in In Re Henderson Receivables Origination v. Campos noted an annual discount rate of 16.8% where the annuitant received $36,500 for the assignment of payments totaling $63,364.94 over 84 months (two monthly payments of $672.32 each, beginning September 30, 2006 and ending on October 31, 2006; eighty-two monthly payments of $692.49 each, increasing 3% every twelve months, beginning on November 30, 2006 and ending on August 31, 2013). However, had the court in Henderson Receivables Origination applied the illogical formula of discounting from “elementary school math” ($36,500/ $63,364.94), the discount rate would have been an astronomical (and nonsensical) 61%. [17]

SBI Factors and Commercial Services Pvt Ltd (SBI FACTORS) SBI Factors, a subsidiary of State bank of India (SBI) is one of the leading factoring companies in India with an asset base of Rs. 700.10 crores as on 30.09.2005. It was established in February 1991 with the primary objective to provide domestic factoring services to Small and Medium Enterprises (SMEs). Factoring is a Collection and finance service designed to improve the cash flow position of SMEs by turning their credit invoices into ready cash. The major strength of the company is that it has put in place a technology driven platform for offering integrated receivables management. SBI and its Associates Banks hold 70% stake in SBI Factors. SBIF offers Domestic Factoring With Recourse and Without Recourse. Purchase Bill Factoring, Factoring of Usance Bills Under LC, Channel Financing of Dealers / Distributors and Export Factoring Facilities. All its products have been well received by its clients. SBIF has ten branches all over the country and it has plans to open three more branches during the year. It has achieved a turnover of

Rs. 1489.54 Crores with Prepayment Outstanding of Rs. 459.35 crores for the year ended 31.03.2005. The profit before tax was Rs. 9.64 crores and PAT Rs. 6.12 Crores for the year 2004-05. It has recorded a NIL NPA position as at 31.03.2005. It has declared a dividend of 8% during the year 2005. It has a market share of 40.30% as on 30.09.2005.