Factoring is a financial transaction where a company sells its account receivables to a third party or a bank at a discount for some immediate money to finance its urgent cash requirements. Normally every company has a credit policy which provides the byers some credit period to pay back all the pending dues; these are called account receivables and termed as asset for the company.
Account receivables are non-cash assets but it helps the companies to withdraw cash from the bank by selling these account receivables and the withdraw amount can vary between 70 -80% of the total account receivables value.
The main characteristics of factoring are
Usually a third party or a bank buys the account receivables; named as a factor
The company sells some of its account receivables at a discount; normally 70-80% of its total value
Three parties are involved in the transaction – Bank or the factor, company that sells account receivables and the debtor
There is some risk associated with the debtor’s ability to pay the receivables within the time frame.
Difference with Bank loan
The main differences between bank loan and factoring are
For Factoring, the emphasis is given on the value of account receivables while more emphasis is given on the credit rating of the company for loans
This is a purchase of financial assets which is different from loan
Factoring involves three parties as specified earlier while loan involves two parties
How does Factoring works
The following diagram shows how Factoring works among the customer, Supplier and the Factor
Factoring Process Flow
Supplier makes a credit to their customers.
Supplier sells its ‘customer a/c’ to the factor and notifies the customer.
Factor makes advance payment to the supplier after deducting the margin and discount charges.
Factor maintains customers account and follows up for payment.
Customer remits the amount due to the factor.
Factor makes final payment to the supplier i.e. margin amount.
Benefit of Factoring
It manages trade debts of the client by maintaining sales ledger, collecting payment and other administration services. The supplier is saved of the administrative cost of book keeping, stationery, postage and management time.
It takes care of the risk aspect of the debt from the supplier when the arrangement is without recourse to the supplier.
It provides advance to the client before maturity date. This improves the liquidity of the supplier.
Use of Factoring in India
Development of factoring started in the year 1990, when SBI and some nationalized banks started factoring subsidiaries. These factors provide pre-payment upto 80% of the invoice value and deal only in inland bills. Factoring services are not extended to financial and investment companies.