Factoring and Forfaiting

Chapter 6Financial Services

M Y Khan

Factoring - Meaning Is a financial service Institution called ‘Factor’ which - Undertakes the task of realizing ‘receivables’,

i.e. accounts receivables, book debts, bills receivables &

Also the ‘Factor’ manages the sales registers, sundry debts of the commercial firms/trading agents , for a commission.

This activity is called ‘Factoring’

Factoring - definition C.S. Kalyansundaram – “ a continuing

arrangement under which a financing institution assumes the credit and collection functions for its client, purchases receivables as they arise, maintains the sales ledger, attends to other book keeping duties relating to such accounts and performs other auxiliary functions.

Can also be broadly defined as an agreement in which receivables arising out of sale of goods/services, are sold by a firm, to the ‘Factor’ , as a result of which the title to the goods/services passes on to the Factor.

Mechanism Seller does not maintain a collection/credit department. After sale, a copy of the invoice, delivery challan, the

agreement, other papers are handed over to the Factor. The Factor receives payment from the buyer on the due

date as agreed, whereby the buyer is reminded of the due date payment amt. for collection.

The Factor remits the money collected to the seller after deducting its own service charges at the agreed rate.

Thereafter the seller closes all transactions with the Factor.

The seller passes on papers to the Factor for recovery of the amount.

Mechanism..

Merchant Customer

Factor

Credit Transaction (1)

Agreement (2)

FactorFinancing (5)

Handing over Inovice(4)

Factoring Contract for sale of receivables.(3)

ReceivingPayment(6)

Characteristics The Nature Similar to bailment contract. Specialized activity

where Factor assumes the risk associated with collection of receivables.

If the debtor does not pay the Factor bears the risk of bad debt loss.

The Form Takes the form of “Invoice Factoring”, as covers

receivables not covered under NI Act. Factoring of receivables helps the firm do away with

the credit department, and its debtors become the debtors of the Factor.

Characteristics… The Assignment Assignment of debt in favour of the factor. This is a basic

requirement for the working of a factoring service. Fiduciary Position Position of the factor is fiduciary in nature, as it arises from the

relationship with the client firm. The Factor is mainly responsible for fulfilling the terms of the contract between the parties.

Professionalism Factoring firms professionally competent, with skilled persons to

handle credit sales realizations for different clients in different trades, for better credit management.

Characteristics… Credit Realizations Help in avoiding the risk of bad debt loss, which

might arise otherwise. Less Dependence. Factor reduces the dependence on banks for

working capital finance. This relieves the firm greatly of the burden of finding funding facility.

Recourse Factoring Non Recourse – the Factor will have no recourse to

the seller on non payment from the customer. With Recourse – The factor will have recourse to the seller in the event of non payment by the buyers.

Characteristics…. Compensation A Factor works in return for a service charge

calculated on the turnover. Factor pays the net amount after deducting the necessary charges, some of which may be special terms to handle the accounts of certain customers.

Types of Factoring Domestic Factoring Export Factoring Cross Border Factoring

Domestic Factoring - Factoring that arises from transactions relating to

domestic sales is known as ‘Domestic Factoring’. Three Types : Disclosed Factoring, Undisclosed

Factoring, Discount Factoring.

Domestic Factoring Disclosed Factoring : Name of proposed Factor mentioned on the invoice, made

by the seller of goods. Buyer to pay directly to the Factor. Could be recourse or non Recourse. Undisclosed Factoring : Name of the proposed Factor not disclosed by the seller in

the invoice. But all sales realization done by the Factor in the name of

the seller. Control of all the monies with the Factor. Quite popular in the U.K.

Domestic Factoring.. Discount Factoring : Is a process where the Factor discounts the

Invoices of the seller at a pre-agreed credit limit with a financing institution.

Book debts and receivables serve as securities for obtaining financing accommodation.

Export Factoring Where the claims of an exporter are assigned to a

bank/financial institution, and the exporter obtains finance on the strength of export documents and guaranteed payments, it is “Export Factoring”

The Factor bank is in the country of the exporter. It admits upto 50-75%, advance on the export claims.

If importer does not honor claims, the exporter has to make the payment to the Factor.

Export Factoring offered as both Recourse and Non Recourse factoring.

Cross Border Factoring It involves the claims of an exporter assigned to a

bank/financial institution in the importer’s country, on the strength of the export documents and guaranteed payments.

International factoring always works on Non recourse factoring model. They handle the overseas credit sales of the exporter. Complete protection to the exporters against bad debts loss on credit approved sales.

Factors take assistance and avail the facilities provided by the exporting country.

For the exporter, once the goods are shipped , his sole debtor is the Factor.

Cross border Factoring...

Methods of dealing: Export factor : exporter informs the the export factor

about the export of goods, to an import client, regarding goods sold on credit.

Import Factor : export factor writes to the import factor enquiring about the credit worthiness , reputation of the importer.

Delivery : exporter delivers the goods to the importer. Then he delivers the relevant documents(invoices, bill of lading, other supporting documents) to the export factor.

Cross border Factoring... Methods of dealing: Credit Information: the export factor works with the

import factor , for credit checking, sales ledgering & collection in importer’s country.

The import factor disseminates credit information about importer, and on maturity of credit period, makes payment to the export factor, on assignment of documents .

Payment: the export factor makes the payment to the exporter upon assignment/collection of export receivables, depending upon the type of factoring arrangement between them.

Full Service Factor Also known as Old Line Factoring Factor has no recourse to the seller, in case of

default by buyer. With Recourse Factoring: - Factor has recourse to the client firm for

irrecoverable book debts. - Factor entitled to recover dues from advance

payment if customer defaults. - They charge the client for maintenance of sales

ledger, collecting customer’s debt etc.

Without Recourse factoring Factor does not have recourse to the client

(seller) in case of default. Factor bears the loss of irrecoverable debts.

For which they charge “Del Credere Commission” as compensation for the loss.

Factor actively involves in the process of grant of credit to customers.

Advance & Maturity Factoring Advance payment by the Factor in the rage of

70-80% of receivables factored. Balance on payment by the customers.

Factor collects interest on the same. This ROI on basis of Prevailing Short term

rate, Financial Standing of the Client etc.

Bank Participation Factoring Variation of Advance and Maturity Factoring The Factor arranges part of the advance

payment through a banker. Net Factor advance calculated as: {Factor Advance Percent X Bank Advance

Percent}

Collection /Maturing Factoring No advance payment by the Factor. Payment by the Factor on the Guaranteed

date or Date of collection. Guaranteed date fixed after considering the

previous ledger experience of the client , and date of collection being reckoned after due date of the invoice.

Advantages of Factoring Cost Savings Leverage Enhanced Return Liquidity Credit Discipline Credit Certification Information Flow Prompt Payment

Infrastructure Boon to SSI sector Efficient Production Reduced Risk

Functions of the Factor Sales Ledger Maintenance Collection of accounts receivables Financing facility for trade debts Assumption of credit risk/credit control and

credit protection Provision of advisory services

INDIAN FACTORING Features : Domestic Factoring With recourse undertakes collection & credit services Advance upto 80% of receivables maintenance of sales ledger, with monthly sales and

invoice overdue analysis. Factors provide payment reports to the clients. Factor’s charge by way of service charges/fee without

guarantee being insisted upon.

INDIAN FACTORING ... Export Factoring: ECGC has been approved by RBI to provide

non fund based export factoring service. ECGC grants 100% credit protection to bills

drawn on approved overseas buyers through endorsement to the policy.

ECGC enters into a tripartite agreement with the exporter and the authorized dealer .

INDIAN FACTORING.. OPERATIONAL PROBLEMS Lack of access to common source of information. Lack of experience and database to take on jobs such as

credit evaluation of clients. Expensive system of multiple databases maintained by

Individual factors. Lack of uniformity in the specialized credit information

agencies. High stamp duty on assignment of debt to Factors. High cost of operations and resulting less profitability for the

factors.

FORFAITING A form of financing of receivables arising from

international trade is knows as Forfaiting. Bank/financial Inst. Purchases the trade

bills/promissory notes without recourse to the seller. Purchase through discounting of the documents .

Entire risk of non payment at the time of selection, covered.

All risks become the full responsibility of the forfaiter(purchaser). Forfaiter pays cash on discounting the bills/notes, to the seller.

FORFAITING…... Characteristics : Essentially involves non recourse bills discounting. Bills of Exchange/promissory notes accepted by

importer, co-accepted by the bank in favour of forfaiting agency , are exchanged for discounted cash proceeds.

Discount rates are charged as a % above Euro Market Interest Rates.

A forfaiter may buy or sell these bills like any other security, in the secondary market.

Forfaiting... Steps Commercial contract signing: between exporter and importer , including basic

terms such as cost of forfaiting, margin to cover risk, days of grace, fee to compensate the forfaiter for loss of interest due to payment delays, etc.

Transaction Exporter sells and delivers the goods to the

importer.

Forfaiting... Notes Acceptance The importer accepts a series of bills /promissory

notes in favour of the exporter for payment including interest charges.

The accepted notes sent to the exporter ,with bank guarantee in respect of the promissory notes/bills.

Factoring Contract Exporter and forfaiting agent enter into a forfaiting

contract .The forfaiter, is usually a reputed bank, including the exporter’s bank.

Forfaiting... Sale of notes The exporter sells the notes/bills to the

forfaiter(bank) at a discount without recourse. Payment the forfaiter makes payment to the exporter for

the face value of the bill/note , less discount charges .The forfaiter may either hold these bills/notes, or sell them in the secondary market .

Forfaiting in India Permitted since 1992 essentially a method of post shipment export

finance. Here also it is non recourse finance, which

converts credit sale into cash sale. Does not lock up any bank limits. Considered valuable medium to long term

post shipment finance for large size exports.