Factoring

Presented by:

Rajesh Kumar

MBA(Finance), ACS, AIII

WHAT IS FACTORING ?Factoring is the Sale of Book Debts by a firm (Client) to a financial

institution(Factor) on the understanding that the Factor will pay for the Book Debts

asand when they are collected or on a guaranteed payment date. Normally,

theFactor makes a part payment (usually upto 80%) immediately after the

debts are purchased thereby providing immediate liquidity to the Client.

PROCESS OF FACTORINGCLIENT CUSTOMER

FACTOR

Definition:• Factoring is defined as ‘a continuing legal relationship

between a financial institution (the factor) and a business concern (the client), selling goods or providing services to trade customers (the customers) on open account basis whereby the Factor purchases the client’s book debts (accounts receivables) either with or without recourse(recourse risk with client non recourse risk with factor) to the client and in relation thereto controls the credit extended to customers and administers the sales ledgers’.

Explanation

• It is the outright purchase of credit approved accounts receivables with the factor assuming bad debt losses.

• Factoring provides sales accounting service, use of finance and protection against bad debts.

• Factoring is a process of invoice discounting by which a capital market agency purchases all trade debts and offers resources against them.

So, a Factor is,

a) A Financial Intermediaryb) That buys invoices of a manufacturer or a

trader, at a discount, andc) Takes responsibility for collection of payments.

The parties involved in the factoring transaction are:-

d) Supplier or Seller (Client)e) Buyer or Debtor (Customer)f) Financial Intermediary (Factor)

Why use Factoring? • Through the use of Factoring receivables are instantly

converted into cash leading to improved cash flows that can help funding of future growth.

• It facilitate an efficient follow up of payments from buyers, which is made possible through relationships developed by factors with client’s buyers.

• Factoring provides credit protection for export sales which enables to do business with buyers who are unwilling to open Letters of Credit.

• Factoring also provides other peripheral services such as advisory services, credit assessment, etc.

Evolution of factoring

• The term factor has its origin from the Latin word, ‘Facere’ meaning to get things done. The dictionary defines a factor as an agent particularly a mercantile agent. Factoring has a long fascinating history which traces back through several centuries.

• In the early stages factors were itinerant merchants who were entrusted with merchandise belonging to others.

Factoring Profile(India)

• Number of factoring companies – 08• From Domestic factoring turnover – 1450

(million euros)• From International factoring turnover - 175

(million euros)• From Total factoring turnover - 1625

(million euros)

• India still has limited number of players engaged in providing factoring services. Most of the players engaged in providing factoring services currently, are

• • Specialized factor institutions

SBI Global FactorsCanbank Factors IFCI Factors

• Commercial banks

HSBCICICI BankAxis Bank

• Specialized financial institutions

ECGC

Factoring is of recent origin in Indian Context.

Kalyana Sundaram Committee recommended introduction of factoring in 1989.

Banking Regulation Act, 1949, was amended in 1991 for Banks setting up factoring services.

SBI/Canara Bank have set up their Factoring Subsidiaries:- SBI Factors Ltd., (April, 1991) CanBank Factors Ltd., (August, 1991).

RBI has permitted Banks to undertake factoring services through subsidiaries.

Factoring Bill clearance to attract private players

• Factoring business in india is dominated by public sector bank and financial institution like sbi global factor and canbank factor. Bank such as hsbc etc also provide factoring.

• Sbi global factor is the market leader with nearly 80% market capitalization.

• Government passed factoring bill in parliament to attract more factoring company in the field.

Factoring business scenario in india

• Factoring business is much lower compare with the other developing countries in the world. India’s factoring volume share is less than 1% of the world factoring business.

• And contribution of working capital requirement of the company by the factor is less than even .5%. Where as globally this is above 5%

Factoring and SME sector

• Factoring is a short term finance for sme’s .and it increases working capital requirement of the company.

• India Factoring & Finance Solutions Pvt Ltd, a joint venture of Punjab National Bank (PNB), along with Malta-based FIM Bank Group, Italy- based Banca IFIS, and Blend Financial Services, Mumbai, is expanding its factoring services across Maharashtra and cities like Pune, Nashik, Nagpur and Aurangabad for entrepreneurs, small and medium enterprises (SMEs) and small-scale industries to provide much needed liquidity for their business

• The company lends minimum Rs 1 crore to maximum Rs 20 crore for the SMEs. Currently, the size of its business is Rs 2300 crore.

• India Factoring is facilitating financial solutions to more than 200 SMEs in Delhi, Mumbai, Chennai, Bangalore, Kolkata, Ahmedabad and Hyderabad

SBI Global Factors Limited (SBIGFL)

• it is the only provider of international factoring, domestic factoring and forfaiting services under one roof in India

• SBIGFL is headquartered in Mumbai with six regional offices - one each in New Delhi, Bangalore, Chennai, Hyderabad, Ahmedabad and Kolkata

• SBI Global Factors Limited (SBIGFL) formerly Global Trade Finance Ltd was promoted as a joint venture by Export Import Bank of India (Exim Bank), West LB, Germany; and International Finance Corporation Washington . It commenced its operations from September 2001. In March 2008, State Bank of India purchased the equity stake of Exim Bank, FIM Bank, Malta, and IFC, and acquired 92.08% stake in the GTF

The NBFC–Factor (Reserve Bank) Directions, 2012

• Any company planning to undertake factoring business will have to register itself as an ‘NBFC-Factor’ with (RBI) and should have a minimum net owned fund of Rs 5 crore.

• Under this act every company other than bank would be registered as nbfc. Every company intending to undertake factoring business shall make an application for grant of certificate of registration as an NBFC-factor to the (Reserve) Bank

Frequently asked questions on factor

• Why should I use factoring?• Sellers don’t have to wait for the usual long period to

get paid by their buyers. The seller will therefore have a healthier cash flow, which will accelerate the growth.

• How much advance can I get?• Advances are made as a percentage of invoice value,

based on criteria such as quality of receivables, number and quality of the buyers and your requirements. Typically upto 80% of invoice value is advanced

• Would Factoring cause any unpleasantness between the seller and its buyers?

• factoring helps the seller to avoid the embarrassment of having to directly seek payment from the buyers.

Would using factoring give buyers the idea that the seller is in financial difficulties?

• On the contrary, International customers now accept factoring as a normal, progressive business service.

It is an indication of a growing organization with keen focus on its core activities like production and marketing and outsourcing non core activities like collection and sales ledger management to experienced professionals.

• Which types of industries are suitable for factoring?• A large number of industries are now covered under

factoring, including automobiles, pharmaceuticals, textile, garment and engineering. In addition to the manufacturing sector, the services sector industries such as travelling, telecommunications, software services and so on are also suitable for factoring

• What are the cost involved in factoring?• There are 3 elements of Factoring cost: • Service fee • Discount charge • One time setup fee • What is disclose and undisclosed factoring?• In disclose factoring , the debtor is informed of the

assignment of debts to the factor Alternatively, under undisclosed factoring, the debtor is not informed of the agreement entered into between the seller and the factor. most of the cases disclose factoring is happen.

As of today,

• Worldwide, factoring volume is more than USD 700 billion a year

• Spread over nearly 60 countries and covering more than 1,00,000 businesses.

• Particularly in developed countries, factoring is an accepted way of conducting business.

Steps in FactoringSteps in Domestic Factoring:

Customer ( Buyer) places the order with Client (Seller)

Client (Seller) obtains a prepayment limit from Foremost Factors.

Client (Seller) delivers goods/services to the customer (Buyer).

Copies of Invoices, along with a Notice to Pay, are submitted to Foremost Factors.

Foremost Factors makes a prepayment advance to the Client (Seller).

Foremost Factors follows up on payment with the Customer (Buyer)

Customer (Buyer) makes payment to Foremost Factors.

Foremost Factors makes the balance payment to the Client (Seller).

MECHANICS OF FACTORING

The Client (Seller) sells goods to the buyer and prepares invoice with a notation that debt due on account of this invoice is assigned to and must be paid to the Factor (Financial Intermediary).

The Client (Seller) submits invoice copy only with Delivery Challan showing receipt of goods by buyer, to the Factor.

The Factor, after scrutiny of these papers, allows payment (,usually upto 80% of invoice value). The balance is retained as Retention Money (Margin Money). This is also called Factor Reserve.

Once the invoice is honoured by the buyer on due date, the Retention Money credited to the Client’s Account.

Till the payment of bills, the Factor follows up the payment and sends regular statements to the Client.

CHARGES FOR FACTORING SERVICES

• Factor charges Commission (as a flat percentage of value of Debts purchased) (0.50% to 1.50%)

• Commission is collected up-front.

• For making immediate part payment, interest charged. Interest is higher than rate of interest charged on Working Capital Finance by Banks.

Different kinds of factoring services

Debt administration:• The factor manages the sales ledger of the

client company. The client will be saved of the administrative cost of book keeping, invoicing, credit control and debt collection. The factor uses his computer system to render the sales ledger administration services.

• Credit Information: Factors provide credit intelligence to their client and supply periodic information with various customer-wise analysis.

• Credit Protection: Some factors also insure against

bad debts and provide without recourse financing.

• Invoice Discounting or Financing : Factors advance 75% to 80% against the invoice of their clients. The clients mark a copy of the invoice to the factors as and when they raise the invoice on their customers.

Process:

• Basically there are three parties to the factoring services as depicted below:

Client customer

factor

BuyerSeller

Financer

BILL DISCOUNTING

• While discounting a bill, the Bank buys the bill (i.e. Bill of Exchange or Promissory Note) before it is due and credits the value of the bill after a discount charge to the customer's account. The transaction is practically an advance against the security of the bill and the discount represents the interest on the advance from the date of purchase of the bill until it is due for payment.

DIFFERENT TYPES OF BILLS DISCOUNTING

• Trade bill discounting

• Accommodation bill discounting

CONDITIONS

• A bill must be a usance bill.• It must have been accepted and bears at least

two good signatures (e.g. of reputable individuals, companies or banks etc.)

• The Bank will normally only discount trade bills.• Where a usance bill is drawn at a fixed period

after sight the bill must be accepted to establish the maturity.

CONDITIONS

• The discount should be based on real trade background.

• The discount tenor starts from the date of discount and expires at the maturity of the bill.

Advantages of Bill Discounting

(1) Safe Employment of Fund: The bank by discounting the clean or documentary bill advances the amount to the payee. On maturity of the bill, the amount is collected from the drawer. The discount is the safe earning of the bank because the bill of exchange is a negotiable instrument. If at any time the bill is dishonoured, the payee is responsible to make the full payment of the bill to the bank.

(2) Certainty of payment: On the maturity of the bill, there is certainty of payment to the bank. It is thus a short term advance with certainty of payment.

(3) The advance is Liquid: As the date of payment to the bank is sure, the short term advance is quite liquid Rediscounting facilities are also available on discounted bill of exchange

Cont...

(4) Free from price fluctuations: The payment made by the bank on discounted bill is free from price fluctuations. The bank realizes the bill at par value.

(5) Profitable earning: The discount rate is usually higher than the rate of interest charged on loan/and advances If therefore offers good earning with no risk.

(6) Facility of rediscounting: The banker has the facility of rediscounting the bills if it is short of funds of any time.

Bill Discounting Vs Factoring

• Short term duration• More paper work• 3 days grace period• Requirement of original

documents• Discounted bills may be

re-discounted several times before they mature for payment

• Long term• Less paper work• Higher grace period• Copies -o.k.

• It can not re-discount in the case with factoring.

TYPES OF FACTORING

Recourse Factoring

Non-recourse Factoring

Maturity Factoring

Cross-border Factoring International Factoring

RECOURSE FACTORING

Upto 75% to 85% of the Invoice Receivable is factored.

Interest is charged from the date of advance to the date of collection.

Factor purchases Receivables on the condition that loss arising on account of non-recovery will be borne by the Client.

Credit Risk is with the Client.

Factor does not participate in the credit sanction process.

In India, factoring is done with recourse.

NON-RECOURSE FACTORING

Factor purchases Receivables on the condition that the Factor has no recourse to the Client, if the debt turns out to be non-recoverable.

Credit risk is with the Factor.

Higher commission is charged.

Factor participates in credit sanction process and approves credit limit given by the Client to the Customer.

In USA/UK, factoring is commonly done without recourse.

MATURITY FACTORING

Factor does not make any advance payment to the Client.

Pays on guaranteed payment date or on collection of Receivables.

Guaranteed payment date is usually fixed taking into account previous collection experience of the Client.

Nominal Commission is charged.

No risk to Factor.

CROSS - BORDER FACTORING It is similar to domestic factoring except that there are four parties,

viz., a) Exporter, b) Export Factor, c) Import Factor, and d) Importer.

It is also called two-factor system of factoring. Exporter (Client) enters into factoring arrangement with Export Factor

in his country and assigns to him export receivables. Export Factor enters into arrangement with Import Factor and has

arrangement for credit evaluation & collection of payment for an agreed fee.

Notation is made on the invoice that importer has to make payment to the Import Factor.

Import Factor collects payment and remits to Export Factor who passes on the proceeds to the Exporter after adjusting his advance, if any.

Where foreign currency is involved, Factor covers exchange risk also.

International Factoring:It means the services of a factor in a domestic business are simply extended to international trade. It depends upon the type of export factoring and the arrangement made by the exporter & the factor.

Types: Two factor systemSingle factor systemDirect export factor systemDirect import factor system

FORFAITING

“Forfait” is derived from French word ‘A Forfait’ which means surrender of fights.

Forefaiting is a mechanism by which the right for export receivables of an exporter (Client) is purchased by a Financial Intermediary (Forfaiter) without recourse to him.

It is different from International Factoring in as much as it deals with receivables relating to deferred payment exports, while Factoring deals with short term receivables.

FORFAITING (contd…)

• Exporter under Forfeiting surrenders his right for claiming payment for services .

• Bank (Forfeiter) assumes default risk possessed by the Importer.

• Credit Sale gets converted as Cash Sale.

• Forfeiting is arrangement without recourse to the Exporter (seller)

• Operated on fixed rate basis (discount)

• Finance available upto 100% of value (unlike in Factoring)

• Introduced in the country in 1992.

COSTS INVOLVED IN FORFAITING

• Commitment Fee:- Payable to Forfeiter by Exporter in consideration of forfeiting services.

• Commission:- Ranges from 0.5% to 1.5% per annum.

• Discount Fee:- Discount rate based on the period concerned.

• Documentation Fee:- where elaborate legal formalities are involved.

• Service Charges:- payable to Exim Bank.

WHY FORFAITING HAS NOT DEVELOPED

• Relatively new concept in India.• Depreciating Rupee• No ECGC Cover• High cost of funds• High minimum cost of transactions (USD 250,000/-)• RBI Guidelines are vague.• Very few institutions offer the services in India. Exim Bank alone

does.• Long term advances are not favoured by Banks as hedging

becomes difficult.• Lack of awareness.

FACTORING vs. FORFAITINGPOINTS OF

DIFFERENCEFACTORING FORFAITING

Extent of Finance

Usually 75 – 80% of the value of the invoice

100% of Invoice value

Credit Worthiness

Factor does the credit rating in case of non-recourse factoring transaction

The Forfaiting Bank relies on the creditability of the Avalling Bank.

Services provided

Day-to-day administration of sales and other allied services

No services are provided

Recourse With or without recourse Always without recourse

Sales By Turnover By Bills

STATUTES APPLICABLE TO FACTORING

• Factoring transactions in India are governed by the following Acts:-

a) Indian Contract Act

b) Sale of Goods Act

c) Transfer of Property Act

d) Banking Regulation Act.

e) Foreign Exchange Regulation Act.

Salient Features of New Bill:

Any company can commence factoring by obtaining registration from the RBI as a non-banking finance company.

Banks or corporations established under an Act of Parliament can also undertake factoring without being required to obtain registration from RBI.

Factors are granted exemption from stamp duty on documents executed for the purpose of assignment of receivables in favour of factors.

WHY FACTORING HAS NOT BECOME POPULAR IN INDIA

• Banks’ reluctance to provide factoring services.

• Bank’s resistance to issue Letter of Declaration (Letter of Declaration is mandatory as per RBI Guidelines).

• Problems in recovery.

• Factoring requires assignment of debt which attracts Stamp Duty.

• Cost of transaction becomes high.

Benefits of Factoring:

Financial Services – 1. Clients will be able to convert their trade debts into cash upto 80% immediately as soon credit sales are over.2. As sales grow the financial assistance grows and both are

proportional to each other. 3. It assures immediate cash flow.

Collection Services-1. Collection work is done by factoring organization, leaving the

client to concentrate on production alone.2. Cost of collection is cut down due to professional expertise of

a factor.

‘Credit Risk’ service – The client need not worry about the loss due to bad debt.Even if the customer fails to pay the debt, it becomes the responsibility of the factor to pay.

Consultancy service – Factors collect information regarding credit worthiness of customers of theirs clients, ascertain their track record and pass the same to their clients. It saves the time of clients as all the work is done by factors on its behalf.

Economic in Servicing – Factors charge less as the overhead cost is spread over a number of clients.

Off-Balance sheet Financing –It leads to reduction in debt & collection problems. The client can utilize the money to reduce current liabilities.

COMPARATIVE ANALYSIS

BILLS DISCOUNTED

FACTORING FORFAITING

1. Scrutiny Individual Sale Transaction

Service of Sale Transaction

Individual Sale Transaction

2. Extent of Finance

Upto 75 – 80% Upto 80% Upto 100%

3. Recourse With Recourse With or Without Recourse

Without Recourse

4. Sales Administration

Not Done Done Not Done

5. Term Short Term Short Term Medium Term

6. Charge Creation

Hypothecation Assignment Assignment

Case Study:ABC Aviation Inc., a fictional reseller of aviation parts, has focused on international sales and was recently awarded contracts by companies in Guatemala and Peru. Two of these contracts were small, totaling $250,000 in sales, and were due in one month. The third contract, however, was valued at $500,000 – a substantial amount for ABC Aviation. The parts for this contract were due in two months. The following table outlines the orders:

Contract COGS Sale revenue Delivery Date Terms

1 $55,000 $100,000 Next month Net 45

2 $82,500 $1,50,000 Next month Net 45

3 $3,00,000 $5,00,000 2 months Net 45

The company has $150,000 in the bank – enough to cover the Cost of Goods Sold (COGS) for the first two contracts, but not enough to cover the third contract. The only way that ABC Aviation can fulfill these contracts is to use financing.

Working with the Export Import Bank:

Ex-Im Bank’s export credit insurance was critical for the success of the transaction. The company managed to get the foreign clients approved, which covered up to 90% of the receivable face value in case of default.This coverage limited the risk to the point that the transaction could be financed using factoring. However, the Ex-Im Bank also has a program that covers up to 60% of the receivable face value if the goods are rejected by the client. This added feature was essential in enabling the company to purchase order (PO) financing as well.

Step 1: Deliver contracts 1 & 2

Before export factoring-

Contracts Cash Bank A/R Payroll General Expenses

2 $1,50,000 $2,50,000 $10,000 $1,37,000

Cash surplus $2500

Step 2: Use export factoring on first two invoices

After export factoring-

Contracts Cash (bank) A/R Reserve Payroll General Expenses

2 $3,50,000 $0 $50,000 $10,000 $1,37,500

Cash surplus $2,02,500

Step 3: Deploy purchase order finance

Immediately after PO fund Contract Cash

(bank)PO

fundingA/R Reserve Payroll General

expense

All 3 $3,50,000 $1,00,000 $5,00,000 $50,000 $10,000 $4,37,500

Cash surplus

$2,02,500

Step 4: Factor the invoice for the last contract

After Export FactoringContracts Cash (bank) A/R Reserve Payroll General

expenses

All 3 $7,50,000 $0 $1,50,000 $10,000 $4,37,500

Cash surplus $3,02,500

What if a foreign client does not pay?

Account debtor default is an inherent risk in international transactions, where collections can be difficult. However, this risk was greatly minimized by using the Export-Import Bank’s credit insurance program.

Thank You.