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Factoring
Factoring provides resources to finance receivables as well as facilitates the collection
of receivables. Factoring involves the outright sale of receivables at a discount
to a factor to obtain funds. Factoring can broadly be defined as an agreement in
which receivables arising out of sale of goods or services are sold by a firm to
the 'factor' as a result of which the title of the goods or services represented
by the said receivables passes on to the factor. From then on, the factor becomes
responsible for all credit control, sales accounting and debt collection from the
buyers. In other words, factoring paves the way by which receivables can be used
for financing.
Functions of a Factor:
- Financing facility/trade debts
- Maintenance and administration of sales ledger
- Providing collection facility
- Control and restriction of credit and assumption of credit risk.
- Providing Advisory Services.
- Financing facility/trade debts
The main function of a factor is the purchase of accounts receivables from his client at a price. The receivables then are assigned to the factor and he grants advances based on the receivables. Where the debts are factored with recourse, the finance provided would become refundable by the client in case of non-payment of the buyer. However, where the debts are factored without recourse, the factor’s obligation to the seller becomes absolute on the date of the invoice whether or not the buyer makes the payment.
- Maintenance and administration of sales ledger
Another function of a factor includes maintenance of the client’s sales ledger. Once a sale transaction is done, the invoice is sent to the buyer of the goods and a copy to the factor. Each receipt is matched with the specific invoice and thus on any date the ledger gives information about the specific invoices that are outstanding and the ones that are settled. Thus the ledger is maintained by the factor under the open item method. Periodically the factor also performs the function of sending reports to their customers regarding the status of the ledgers.
- Providing collection facility
The collection problems of the customers are solved due to the existence of the factor. The factor undertakes the collection responsibility and employs his manpower and time to collect the receivables payment. Thus he saves the valuable time of his customer who can concentrate more on his main work of sales. The factor uses sophisticated infrastructural back-up and this makes him efficient to collect the receivables in time and even for the payer, it is a credit issue for him if he fails to meet the settlement date.
- Control and restriction of credit and assumption
of credit risk.
One of the important functions of a factor is the assumption of credit risk, especially when the receivables are factored without recourse. The factor fixes the credit limit for the approved customers in consultation with his clients. He undertakes to purchase all the receivables of those customers within this fixed limit and he assumes the risk of default in payment by the customer. Thus the client of the factor is benefitted in two ways: factoring relieves the client of his collection work and he provides information on the credit worthiness of each individual customer of the client so that he can exercise better credit control hence forth.
- Providing Advisory Services.
The factor provides a variety of incidental advisory services to their clients like:
- What is the perception of the client's products?
- What are the changes in the marketing strategies and what are the emerging trends?
- Audit of the procedures followed for invoicing, delivery and dealing with sales returns.
- Introduction to the credit department of a bank or subsidiaries of banks engaged in leasing, hire-purchase and merchant banking.
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Advantages of Factoring:
Cost of factoring:
- It offers immediate cash.
- Eliminates credit risk.
- It reduces overhead because the credit examination function is no longer required.
- Provides financial advice.
- It allows for receipt of advances as required on a seasonal basis.
- Strengthens the Company’s balance sheet position.
- High cost involved
- Negative impression left with customers as a result of the change in ownership of receivables
- Factors may antagonize customers by their collection methods
Factors provide the factoring services at a cost also called as the discount charge.
The financial manager should compute the costs of accounts receivables financing
and select the least expensive alternative.
Example:
A factor will purchase the company's $240,000 per month accounts receivables. The
factor will advance up to 80% of the receivables for an annual charge of 14% and
a 1.5% fee on receivables purchased. The cost of this factoring arrangement is:
| Factor fee ($240,000 per month x 12 months x 1.5%) | = | $43,200 | |
| Cost of borrowing ($240,000 x 80% x 14%) | = | $26,880 | |
| Total cost of Factoring | = | $70,080 |
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