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Factoring- all you need to know about Invoice Factoring

 

FACTORING- ALL ABOUT FACTORING, WHAT IS FACTORING, THE DEFINITION OF FACTORING, HOW DOES FACTORING WORKS, TYPES OF FACTORING, ADVANTAGES AND LIMITATIONS OF FACTORING

Factoring

 

FACTORING- TABLE OF CONTENTS

  1. What is factoring? 
  2. Definition of factoring
  3. Why is factoring needed?
  4. What is a ‘factor’? 
  5. Ideal candidates
  6. How does factoring work?
  7. Types of factoring services
  8. Difference between factoring and short-term finance
  9. Difference between factoring and bill discounting
  10. Advantages
  11. Limitations
1) What is factoring

Factoring is an effective financing tool to convert your accounts receivables into liquid cash thereby avoiding blockage of funds in the idle current asset- accounts receivables. It refers to a financial transaction and a type of accounts receivables finance in which a business sells its accounts receivable to a third party (a “factor”) at a discount. It is a method of converting a non-productive, inactive asset (i.e. receivable) into a productive asset (viz. cash) by selling receivables to a company that specialises in their collection and administration.

2) Definition of factoring

It can be defined as “a business involving 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) whereby the factor purchases the client’s accounts receivable and in relation thereto, controls the credit, extended to customers and administers the sales accounts”

3) Why is factoring needed?

The factoring transaction occurs between a business (the borrower) and a lender (often a factoring’ company as opposed to a traditional commercial bank). It is only available as a funding source for companies that sell on credit terms, meaning that a borrower (the vendor) sells a good (or service), generating an invoice to its buyer for payment at a later date (terms maybe 30, 45, or 60+ days). This expected future payment sits as an account receivable (a current asset) on the vendor’s balance sheet.

For a number of companies, cash may become a scarce resource if it takes a long time to receive payment for goods and services supplied by them. Such a current asset in the balance sheet is, in fact, illiquid and serves no business purpose; it is much better to sell that asset for cash which can be immediately employed in the business. A ‘factor’ makes the conversion of receivables into cash possible. 

4) What is a factor

A factor is an intermediary agent that provides cash or financing to companies by purchasing their accounts receivables. A factor is essentially a funding source that agrees to pay the company the value of an invoice less a discount for commission and fees. The factor can be a bank, institutional lender, trade fiance provider or any other financial intermediary.

The factor is to perform at least two of the following functions-

(i) finance for the supplier, including loans and advance payments;

(ii) maintenance of accounts receivables and sales accounts;

(iii) collection of accounts receivables, and

(iv) protection against default in payment by debtors;

It is an absolute sale of an asset and therefore not a loan, it allows a business to immediately increase its cash flow without the introduction of long-term debt. This, therefore, improves the balance sheet and debt to equity ratio among other things.

Businesses utilize the services of a factor to immediately increase their cash flow. However, the overall services a factor can provide a client reach far beyond cash flow. The ancillary services and the partnership that is ultimately formed becomes the basis for long-term client retention.

5) Ideal candidates for factoring

No two factors will have similar underwriting parameters when evaluating a potential factoring client. Some factors utilize similar underwriting guidelines as a cash-flow lender, others simply utilize a collateral model and some employ a combination of both. A business is a reasonable candidate for factoring as long as it can demonstrate the following:

  • It is providing reasonable credit to other creditworthy businesses;
  • The accounts receivables are unencumbered;
  • It has the ability to absorb or pass on the factoring fees;
  • The business is operationally compatible with the factor; 
  • It will improve the company’s cash position and enable it to accommodate increased sales.
6) How does factoring work
a) Choose A Factoring Company

The first step to starting invoice factor is choosing a credible factor company. There are many factor companies to choose from, but you want to be sure to select one that is right for your business needs. Most factors are small to medium-sized companies that specialize in specific industries. It’s best to choose a factor company that has experience in your industry.

Be sure to think about these items when selecting a factor company.

    • How long has the factor company been in business?
    • Is it recourse or non-recourse?
    • Have they worked with your industry before?
    • What is the length of the contract?
    • What are the minimum and the maximum amount of invoices you can factor per month?
    • What is the cost, including the fees and/ or interest?
    • Are there any hidden fees?
    • Average time to process a transaction?
    • Do they offer back-office support such as accounts receivable management and collections?
b) Account setup, application and due diligence

Once you choose a factor company and sign a contract, you’ll select which clients you want to factor. The factoring company will conduct due diligence on the clients you wish to factor. From there, the factor company sets a maximum dollar amount on the invoices you wish to factor.

The next step is to fill out and submit the financing application. Each factor has its own application process, though they are all similar. Factor companies need the application to evaluate the transaction and determine if it’s a good fit for both parties. During their due diligence, factors evaluate if your:

    • Customers have good credit track records
    • Invoices are free from liens
    • The company has no major problems

Due diligence is usually quick, and you can often get a proposal the same day you submit your application.

c) Proposal and contract

The factor company will send a proposal to you after they finish reviewing the transaction. Most proposals have three key pieces of information:

    • Advance rate (1st instalment)
    • Factoring rate
    • Length of term
d) Notice of Assignment (NOA)

The factor company sends a Notice of Assignment (NOA) to every customer whose invoices you want to factor. The NOA is a standard industry document and is used by every factor. It advises the customer’s accounts payable department on how to handle invoice payments. This process is done once for each customer.

e) Send Invoices & Get Cash

Send your invoices to the factor company. When the company receives the invoices, you’re advanced a percentage of the invoice directly into your bank account. Most of the time, the payment will be received on the same day you sent the invoice.

f) Factoring Company Sends Invoices To Your Customer

The factor company then sends the invoices to the customer for processing and payment.

g) Customer Pays the Invoice

Your customer sends payment at their agreed-upon terms to the factor company. Once the factoring company receives payment, the remaining percentage of the invoice is remitted back to you, minus a factoring fee.

Read more on alternative financing sources: 

7) Types of Factoring Services

The factoring facilities available worldwide can be broadly classified into the following.

a) Full-service non-recourse factoring

Under this method, book debts are purchased by the factor, assuming 100 per cent credit risk. The full amount of invoices has to be paid to clients in the event of debt becoming bad. They also advance cash up to 80-90 per cent of the book debts immediately to the client. Customers are required to make payments directly to the factor. The factor maintains the sales ledger and accounts and prepares age-wise reports of outstanding book debts.

b) Full-service recourse factoring

In this method of factoring, the client is not protected against the risk of bad debts. He has no indemnity against unsettled or uncollected debts. If the factor has advanced funds against book debts on which a customer subsequently defaults, the client will have to refund the money. 

Most countries practice recourse factoring since it is not easy to obtain credit information, and the cost of bad debt protection is very high. This type is often used as a method of short-term financing, rather than pure credit management and protection service. It is less risky from the factor’s point of view, and thus, it is less expensive to the client than non-recourse factoring.

c) Disclosed factoring

The factoring in which the factor’s name is indicated in the invoice by the supplier of the goods or services asking the purchaser to pay the factor is called disclosed factoring.

d) Undisclosed factoring

In this type, customers are not informed about the agreement. It involves the factor keeping the accounts ledger in the name of a sales company to which the client sells his book debts. It is through this company that the factor deals with the client’s customers. The factor performs all his usual functions without disclosing to customers that he owns the book debts.

e) Domestic factoring

When the three parties to factoring, i.e. customer, client, and factor, reside in the same country, then this is called domestic.

f) Export factoring

Also known as cross-border factoring is one in which there are four parties involved, i.e. exporter (client), the importer (customer), the export factor and the import factor. This is also termed the two-factor system.

g) Advance factoring

Under this, the factor advances cash against book debts due to the client immediately. 

h) Maturity factoring

It implies that payment will be made to the client on maturity. . In the case of non-recourse maturity factoring, payment is on maturity or when the book debts are collected, or on the insolvency of the customers. In this case, the factor pays the client when the book debts have been collected. The client with sound financial condition and liquidity may prefer maturity factoring.

i) Invoice discounting

Clients collect payments from the customer directly and pay to the factor.

j) Bulk factoring

Under this, full-recourse can be done by the client and administration and collection are done in his own ways.

k) Agency factoring

In this, finance and protection against bad debts are done by the factor, and administration and collection are done by the client.

8) Difference between factoring and short-term financing

Although factoring provides short-term financial accommodation to the client, it differs from other types of short-term credit in the following manner

  • It involves the ‘sale’ of book debts. Thus the client obtains advance cash against the expected debt collection and does not incur a bad debt.

  • It provides flexibility as regards credit facility to the client. They can obtain cash either immediately or on the due date or from time to time, as and when he needs cash. Such flexibility is not available from formal sources of credit.

  • Such financing is a unique mechanism which not only provides credit to the client but also undertakes the total management of the client’s book debts.

9) Difference between factoring and bill discounting

Factoring’ should be distinguished from bill discounting. Bill discounting or invoice discounting consists of the client drawing bills of exchange for goods and services from buyers, and then discounting them with a bank for a charge. Thus, like factoring, bill discounting is a method of financing. However, it falls short of factoring in many respects. It is all of the bills discounting plus much more. Bills discounting has the following limitations in comparison to factoring:

  • Bills discounting is a sort of borrowing while factoring is the efficient and specialised management of book debts along with enhancing the client’s liquidity.
  • The client has to undertake the collection of book debt. Bill discounting is always ‘with recourse’, and as such, the client is not protected from bad debts.
  • Bills discounting is not a convenient method for companies having a large number of buyers with small amounts since it is quite inconvenient to draw a large number of bills.
10. Advantages of factoring

The merits as a source of finance are as follows:

  • Obtaining funds through factoring’ is cheaper than financing through other means such as bank credit;
  • With cash flow accelerated by factoring, the client is able to meet his/her liabilities promptly as and when these arise;
  • Factoring as a source of funds is flexible and ensures a definite pattern of cash inflows from credit sales. It provides security for a debt that a firm might otherwise be unable to obtain;
  • It does not create any charge on the assets of the firm;
  • The client can concentrate on other functional areas of business as the responsibility of credit control is shouldered by the factor.
11. Limitations of factoring

The limitations as a source of finance are as follows:

  • This source is expensive when the invoices are numerous and smaller in amount;
  • The advance finance provided by the factor firm is generally available at a higher interest cost than the usual rate of interest;
  • The factor is a third party to the customer who may not feel comfortable while dealing with it.

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