Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. A business will sometimes factor its receivable assets to meet its present and immediate cash needs. Factoring is commonly referred to as accounts receivable factoring, invoice factoring, and sometimes accounts receivable financing. Accounts receivable financing is a term more accurately used to describe a form of asset based lending against accounts receivable
In return, the factor makes a cash advance and a statement to the client. The factor then sends a copy of all the statements of accounts, remittances, receipts, etc. to the customer, on receiving them, the customer sends the payment to the factor.
In case of export factoring two ‘factors’ are involved. The factor in the customer’s country is called “Import Factor” while the one in the client’s country is called the “Export Factor”. All the transactions remain similar in the case of international factoring, the only difference being that the export factor has to send the shipping documents to the import factor and the import factor has to pass on the ultimate collection to the export factor.
Steps Involved in Factoring:
The steps involved in factoring are discussed below:
- The customer places an order with the seller (the client).
- The factor and the seller enter into a factoring agreement about the various terms of factoring.
- Sale contract is entered into with the buyer and the goods are delivered. The invoice with the notice to pay the factor is sent along with.
- The copy of invoice covering the above sale is sent to the factors, who maintain the sales ledger.
- The factor prepays 80% of the invoice value.
- Monthly Statements are sent by the factor to the buyer.
- If there are any unpaid invoices follow up action is initiated.
- The buyer settles the invoices on expiry of credit period allowed.
- The balance 20% less the cost of factoring is paid by the factor to the client.
Advantage of Factoring:
- It is help to improve the current ratio. Improvement in the current ratio is an indication of improved liquidity. Enables better working capital management. This will enable the unit to offer better credit terms to its customers and increase orders.
- It is increase in the turnover of stocks. The turnover of stock into cash is speeded up and this results in larger turnover on the same investment.
- It ensures prompt payment and reduction in debt.
- It helps to reduce the risk. Present risk in bills financing like finance against accommodation bills can be reduced to minimum.
- It is help to avoid collection department. The client need not undertake any responsibility of collecting the dues from the buyers of the goods.
Limitations of Factoring:
- Factoring is a high risk area, and it may result in over dependence on factoring, mismanagement, over trading of even dishonesty on behalf of the clients.
- It is uneconomical for small companies with less turnover.
- The factoring is not suitable to the companies manufacturing and selling highly specialized items because the factor may not have sufficient expertise to asses the credit risk.
- The developing countries such as India are not able to be well verse in factoring. The reason is lack of professionalism, non-acceptance of change and developed expertise
Forfaiting is a form of trade and supply chain financing. It involves the purchase of future payment obligations on a “without recourse” basis. Forfaiting can be applied to a wide range of trade related and even purely financial receivables and payment instruments.
Forfaiting is a means of financing used by exporters that enables them to receive cash immediately by selling their medium-term receivables (the amount an importer owes the exporter) at a discount, and eliminate risk by making the sale without recourse, meaning the exporter has no liability regarding possible default by the importer on paying the receivables. The forfaiter is the individual or entity that purchases the receivables, so the importer is then obligated to pay the receivables amount to the forfaiter. A forfaiter is typically a bank or a financial firm that specializes in export financing.
Advantages of Forfaiting:
Forfaiting eliminates all risk of the exporter not receiving payment, including credit risk and transfer risk, as well as risks posed by foreign exchange rate or interest rate changes.
By transforming a credit-based sale into a cash transaction, forfaiting simplifies the transaction, providing immediate cash flow and eliminating collection costs for the seller and the need to carry the accounts receivables on its balance sheet as contingent liabilities.
Forfaiting is flexible and can be tailor-made to suit the needs of the exporter and adapted to a variety of international transactions. It can be utilized in place of credit or insurance coverage for a sale. It is helpful in situations where a country or a specific bank within the country does not have access to an export credit agency, allowing an exporter to transact business with buyers in countries with high levels of political risk.
LC Bill Discounting
Discount Bills drawn under Letter of Credit issued by Nationalized and reputed Private Sector Banks or reputed Co-op. Banks and foreign banks.
The Bills drawn should in strict conformity with the terms of the LC & should have arisen out of bona fide commercial or trade transactions.
Documents to be submitted
- Bill of exchange: In respect of Bills to be discounted drawn under L/C, all the documents mentioned in the Letter of Credit should be submitted by the party alongwith the original L/C.
- Receipted Challan being proof of delivery of goods/ Documents of title to goods evidencing despatch of goods (RR/ LR/ shipping) documents.
- Any other documents as required by the bank at a later stage.
- Service charges as applicable.