Credit Factoring and Bill Discounting

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    CREDIT FACTORING AND BILLDISCOUNTING

    "Factoring is bmh a / t"r laru:fu l technique and amanagement service. It is a method of convert-in g a p ass.iv e asset into an active ~genl o f com -mercia l g .row th . In part~ it is a na n:.J}vet to themer,ea.sing complexi ty and specializatim ofmodern business. Velie/oping as a response tosuch iflflu ence s~ facto ring , l 'Ogetner w ith o th ernew fintlndal techniques such a s leasing, hasestabl ished itself as an importan t tool for th ehusband.ing of SCarce resources. '.'

    - Melvyn Westlake

    I. . l'ttEANING OF' FACTORINGThe term tacter comes born the Latin Verb ' fcere' which means 'tomake' Of 'to do' ..Literally, therefore, factor is an agent who gets things done

    0[1behalf o r others ..Accordingly, for yean, the term factor has been used asreferring to a mercantile agent who gets th:ings done 0'.0 b ehalf of someagent, either d]f:i(;ioscdor undisclosed ..Thishas been the legal interpretationof the term factor, 1 who is one of the two main classes of mercantile agents,the other bei.ng the broker. The only distinction between a broker and a f a e -tor is th..dthe latter often M~llsthe goo d!iin 'Il.isown n!!_lll.:e: an.disf'!llJu passes-s i o n 0:( t h e .ooas:- R!!d [ 1 1 5 1 ; )efllioyslllle.n 0[1 th e ,g .onds.

    However, when used as "credit factoring" or simply "factoring" , imply-log a sepci alised financial mlTvioe , we lift the tradi tional form of facclor.ingfrom the op~m:ling levels and put him as a specialised flnaneier who is noteoneerned with the selling of goods, but: only with collection of debts OIl1. H~I~bmy'~LtnVHl! Eill l ' t lmd (3ru edn, p:ll8. 3t :12) defines u factor as a mercandle ~:!lentwhoin tn e o rr~Y I1 ~ryo urs e 0 1 tnlSbn~SlIbentrusted w ilh ilie p io l:t o f ,g oo o s or th e documentso f Hne . t 'hcrctn fm tn e purpose of s~h~_

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    behalf of others and financing based upon accounts recelvabtes, IIIdevelopment, factoring is an asset based means of financing as wellspeelalised service, being thepurehase of book debts of a c om pa. l1 j ' b yfactor, thus releasing the capltal t ied-up in account 's receivables anding a financial accommodaticntc the company, Tl1C hook debts wireto the factor and it is he who collects them as and when due. The e llthis service is in the form at 1 1 . discount or rebate deducted from the'Ihus, between the supplier and the customer there en~~rsan intcrmedlwho per forms a. f iQ.

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    Types of factorin.g arrangements 559ever. th e , I< lcto r m ay no t abso rb th e risk o f bad -d ebts , < : 1 5 he ma y d is co un t thebillss~bject to the term of "recourse", that is. reverting back tothe clientshould the ctlsttome:r fail to pay the bills. Simibrly, the coHect:ioll8:l1daccount:ing, .functions may also be left to the client. -

    All the above servicescun be provided separately by di.ffertl!lt agencies.Fin an ce m ay be prov id ed on securH -; ' o f acco un ts rece iv able s by banks andot"he t f inRnciers" R i sk involvedin bad debts may be absmj"bed by insurers.Debf .coHec: t ion functioll may be ass igned 10 common collection agencies(common ahroad, though [lot yet developed in our country), (loci computeragendes m a y administe:r the sales ledger. "But the factor uniq udy brings all~hQ~escevlcestcgether in one p '~: lCkage.The actual purchase oftra.de debts-as opposed to their useas coilarcral=-is also s ingular tn [~.C'todng,This isb ec au se (h e fa ctG .rin g formula res-C)Ies tn tl ]egal .1.I.mbi.guiies in he ren t in th epure hese o f tra de debts, ,.l2. F.ACTORINGANDBILI~-IDISCOUNTlNG

    Fa cto rin g a nd bill~ d:U ,-,;;o u.n tin gh av e a t : l 1 in , th ough pe rc:e pti.bie , line ofdist inct ion w hich is blurred q uhe o ften :in p a rlan ce . B ill diwoun.ting, Cl; t l1edin USA a s "receivablesfinandng" o r " invoice :di .' i- count ing", is a m ere fin an -cial funct ion QJ'! . [ ' 1 . one - o f f basis. Thefactor n ot c :m ]yprQvidc~ ad ditio na l se r-vices m en tio ne d e arlie r, but also often plIfchm;es the client's entire turn-over. III form> an invoice di scount ing agreement tesem hies a ~~ctor i I lgagreement in that the financier purchases th~ debts and the client makesmuch th e S,oJiITiC warranties COrl cem ing th e ir v a lid ity and c.nJo:rceabili ty,

    H ow eve r, !h e s irnH a r.ity go es little farther. The m a :in d jf e re n ce c~ b e-twe en illv o 'i ce d iscoun ting and factoring are

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    In a bank participation facloring, the bank takes a floating charge overthe diem'~' eqtiity, that is, the amount that the factor has yet to pa.y to theclientvwhich is obviously a transformed receivable foil' the client. Ora thebasis of this floating charge, the bank: agrees to lend an amount to the clientThe ellent, thus. has a double f inancing .It may be doubted u. to what could be the purpose of the bankfinaneiagon '[he basis of the client's equity; the bank could finance directly on an

    assignment of the client's debts. However, itmay ~c noted [hal the arrange-ment of bank participation in factoring enables the bank to finance morethan what should otherwise have been possible. This is because the bank is.in the latter case. Icnding on the basis of the factor's credit strength andbecause of the fac.t that the factor is policing the accounts receivables nf ~h~client through effective administration and monitoring,

    560 Chup, 2-Credit Factoring and Bill Discountinghas no recourse to the client in the event of non-payment of the bill by thecustomer. The factor rhus assumes the risk of bad debts .. However, the riskabsorbed by the factor is only credit-risk. That is, jf the customer fails to paythe 01Usfor any reason other than financial incapacity; the factor doe shavea recourse to the clientIn recoursc'factoring, although the debt is assigned to the factor, thecredit risk still remains with the client. This is afforded by keeping a recourseprovision permitting the factor to take recourse against tile client in theevent of non-paymenrbj the client.

    The only difference between recourse factoring and bill discountlng isthe nun-financial services rendered by the factor. Apa11 from this. since thecredit-riskis with the client both in recourse factoring and bill-discounting,the two almost resemble, and therefore, recourse factoring isoften saiJ to hea specie of bill-dlscountmg rather than of factoring.3. : 2 : AdvHn~ factoring and maturity factoring

    Like the variation of the absorption of risk elerne nt, the factor may al~nvary the financing involvement, He may agree to pay to rhe client for thebills purchased by him either immediately or Oil maturity or collection,"Maturity" date ian agreed-upon period after which the factor makes thepayment of the bills to the client, When the factor makes immediate pay -ment to the client: i t is called "advance" factoring and the other case is called"maturity" factoring.In advance factoring, the factor provides financial accommodationapart from the non-financi al servj ce~ rendered hi' him. A dvance payme ntsnormally range up to 80% of the invoice valu e. The balance is k flOWfI as t beclient's e.quity or the facto r'S . rl'' se .r ve and is payable on maturity or Or! actu ..lcollection.

    Maturity financing is more uncommon. His mostly resorted to by suchof the clients who have subsranual capital build-up and are interested onlyin. the non-financial services offered by the factor.3.3 Bank participation factoring

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    Ber:efits of factoring 5613.4 'su pp .H e r g ua ra nte e fQ cto rin g

    SuppUer guarantee~fact:olifig, also known as drop shipment faetorlng,QCCI1n. when the client is a mediator between the supplier and the customers.For example, the client who is distributor or wholeseller, in such a case, thefa cto r g ua ra nte es to th e supplie r' aga in st the invoices raised b y the supplierupon the client The goods may be delivsred di.roctly to the customers. TIleclient thereafter raises bills on the customers and assigns them to ' the factor,TIle factor has thus enabled the clien t to make a gross profit with n o f inancia linvolvement at all,3.5 Conftdential. factoring

    Wheu the fact of a factoring arrangement is kept confldential, and theclient hlmself collects the bins without intimating to the customers that thehi ll s, have been assigned to the factor ,it is , a case of confidential factoring.The eonsideraf O'IllS fo r ch oo sin g this fOfl t l1 o f f ac to ri ng may be ma_ny .4. BENEFITS OF FACTORING

    Th e 'V a st s i!:.'1 lifica llC - e an d immense po ten tia lities o f factoring needhllrdly 'be stressed. A ny businessman by sheer instinct may understand howth e irregular and fiot-wl'toUy warranted! expansJon :i n trade credit . hasresulted inte bulgin 't work~ cBleital requjr~ents. Further. indiscipline il:'l,the trade credi t mar.ket n a s m . e the eollecrlon department's job as difficult11 $ of public. enforcement agencies. It was agal!lst this backdrop that the Tau-don Cornnn t t ee" recommended the creation of a Bill market in the countryby developing the habit of bm discounting among the commercial banks.While cornmerclal banks can be pieneers in th e field of factering as in b.il]discounting theprocedural snagsand slackness which. experience hasassociated with this sector of 'the finance market has reinforced the necessi tyof privatesector factoring firms.

    10 words o r Westlake,~ "in a mature Industrialised society there arem any w ays by which a ll enterprising company can ra is e c ap ita ], but each basits price, whi:ch may in some cases j be geared to ultimate use of the funds,\For Us part, factoring offers a distinct solution to the problems posed bycapital tied-up in trade debts. When Q,lOney is outstanding (11 60 Of 80 daysthis, means either that mo:;ecapital is dep)oy~d in the business, than would bedictated s imply by the production cycle ~or ' that expansion ]5 beill_g retardedbecause insuf6d,ent funds are left for production". .The services rendere-d bya factor may be classified under two he,ads-financial Md non-financial. The non-financial services include the real oper-atjooal seretees provided by the factor. The fi nancial services indicate thebenefits wh.ich are likely to accrue to theelient as 1 1 . result of the release of theca .p i.l3 iltie d -u p in a cco un ts re ce iv able s.

    II I I

    4. Study Group to F lam e Gu id e lin e s f or F fillow u p u fB a n k Credit.5 '.W e~ tr~ ke , M : op. c J ~ , r.2.L.F.-36

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    562 Chap. 2-Credil Factoring ~nd Bill Discounting4.1 Financial benefits

    I. Impooyes current ratio : The amount tied up in accoumsrecelvaslesreleased by fac:~orillg may be used to pay-off the current ]iabiJities. This mayhave the effect of j~provi:n;g the current ratio position of the client; Anexample sh an H lus trn te th is ; -

    Blance.Shoot before t-u.etoring:Current Lwbiliti.es~

    S u n d r y CreditorsO th er .U l3J biL i.tie s

    C a s h80,COO D e b to rs . ,20,000 Stock in trade,

    10.0001,00.,00050,000

    1,00 ,000 1 ,60,000

    Current U;ibUUj(1S~Sundry CreditorsOther liabilities

    Current R 0 1 I ! ti Q : :; ; : ::1 . I) : 1.Bal an ( )e -Shee t a f te rf .a d : o ri_Qg

    Current A~C$~NU Cash

    2 0 ) C M JO D u e fnJITI f a c t t : l < rS tc ck- ln - T :rad,e]0.,00020,0(1)50.,000

    20,000 80,.000Current Ratio::;;:; 4 : 1 1 .

    Wn.the above example ~ the client has si~ply disoomlted the accountsreceivable of Rs. 1 )JO,OOOat 80% and usedthe proceeds to p O l l y off th~ ere-dltnrs. This has had a dramatic effect on the current ratio,2. Prom.pt payments .mil improl'eiI credit s : t~ndl :mg !With the aeceler -ated ci"lsh-flow.s via factoring, the clierrt is In a position to avail of promptpayment diseouats from suppliers, It may be noted th at prompt payment dis~counts often have < 1 ! return in terms of interest of as much as 36% .Prompt-ness in making payments also increases the market credit of the. fum.3. EIim~ !ll .!!. 't ionof disc(lUllils p!l!id = With fa cto rin g faci li ty th e clien t sha llbe in position to provide credit to its customers and thWi elimlnate the dis-

    counts paid. to them at the sam e tim e in crea sing its own returns,4_ Accelerating expanRion : The cash flows released from the acoounft~can be deployed in fresh expansion plans.S.]ncre-,;'l.'1;esopera.tiug leverageD; .By.relasi:rng the funds tied. in operating

    assets, thefac10dng mechanism facilitates !TIGre lnvestments in f ixed assets ,.

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    E;mergent.Y! of the credilfdctor 563thus increasing the degree of operating leverage.

    O.Av o , W - O jncreased debt ~A s a resui~of f a , c t o r i n g the finn i i i ; < IIble to raiseshort-tetm funds out of its own assets. This avoids the necessity to knock atthe d oors of lenders,

    7 In cre ase s re tgU l'1IJtlgcapital: Factoring increases the return on capital,i f the geneml returns in the business are more than the service charges paidto the factor. This llliIy be understood] by the s]mp]e reason that with thef inance provided by the factor , rh e clien t sh a ll be able b) do ]J :1 .O 'feusin ess ,.which can again be factored. This increases the volume of business, Thus,net gains accrue to the client if his. general business returns are moreth an thecast o f factoring,

    Ii. F\Icxlb:iliit;yand free frem legO 'Ilprt:Jibllem.s1 Fm :.1 orin gis a remark ablyflexible form of fln!hollldthedam of preventive measure burst,"

    2. EffccliV>e a d l ' 1 l i n L . . . : t t o l ! l i o n ohalcs joorn,,~ : On assignment of the bookdebts to the factor, the sales journal. shall be administered by the f~tt(Jf. Inbusinesses wherethere are number of customers. the administratien of salesledger takes alot of attention. 'fbi!'. Silves the client time who may devotemoreattention to production and other functional areas,3 . C : re d Iit d lils cip .Un e : Th e f~H.;tO]"sp.l . 'Ofession a lapproach in collection ofdebtsinculcates a discipline among the customers whie.h becomes the client'spermanen t asset

    5. EMERGENCE OF 'rHE CREDIT FAc'rORThe emergence of the credit factor W a s from its parent 5:pede---'the

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    564 C hap. 2-C redit .Factoring afj.d Bill D i .r ;co .r .m tmgbusiness of agent factoring (commission agency) sharply declined. Theerstwhile factor changed from mercantile agency to merely financing againstreceivables. It is said that in 18H9,the New York agent factors, OelbeTDlanoDonmerick & Co, was the first to drop its,selling and storage functions andto continue merely the floancin.g function. Factors were traditional1yassociated primarily with the textile industry. Even the newly developedbreed t)f credit factors remained associated with textile industry only,

    In 1904; the first accounts receivables financing company was formed inChicago makl og loans 01'1 assigned accounts. Till this time factorins hadextended beyond the textile industry only very timidly. But in the greatdepression of ]930'5, the textile lndilS'[:rywas great1y crushed, thereby fore-ing the excurslon o f the, factors to wider pastures.In 19'63. the Controller of Currency ga'liethe ruling permitting commer-cia] banks to enter into factoring. Th is led to the entry of commercial banks,and by 1970, the tum over of total business transacted by the factors h~dreached about $12flOOmillion.

    In England, Germany, Australla, New Zealand. Israel, Japan, S01l1thAfrjca, Philippines, Hongkong, Singapore. etc., factoring got establishedbetween 1.970to 1975. 1 1 1 England, factoring is today a rether prosperingbusiness, -In India, while bill-discounting has existed with commercial. banks andlocal financiers aU along, fm:.:toring < IS such, has begun only in the recentwake of financial companies. Dilly some of the financial compani es haveannounced plans to carryon factoring businee .., but what is being transactedcurrently is mostly a biUdiscountjng on one-off basis, Non-recourse factor-jng hardly exists at an, However; as credit needs , grow, the necessity todevelop more and more asset -ba...ed finaneing instruments becomes re]tFACTORING IN INDIA HAS AN lJ'NUM1TED AND UNTAPPED

    SCOPE, NOT ONLY FOR THE BANKERS, ,BUT ALSO FOR rasSPECIAUSFD FINANCIAL INSTITUTIONS, .PARTICULARLYTHOSE WHO ALREADY HAVE TAX-SHELTER FROMACTIVITIES LIKE LEASING. LOOKED FROM A MACRO-ECONOrdlC STANDPOINT. lHE DEVELOPMENT OF FACTORING SHAll.. BE ONE STEP' FORWARD TOWARDS THE FINAN-CIAL SPEClAUSATION AND wru, BE CRUCIAL IN BRINGINGOUT OF TEXT-BOOKS THE RARER SKILLS OF SPECIAUSEDCREDIT ANALYSIS, PIll", what is vcry significant as envisaged by theTandon Committee. is accredit discipline in the market, which is as of nowvery peculiarly absent"6. THE LEGAL ASPECTS

    Legally speaking, a factor i~ike any other trader who buys reeeivables,The legal relations between the factor and his dient shall be governed by afactoring agreernenf (oft.eu called master agreement), which regulates theterms upon which the factor will purchase receivables due to the client fromthose to whom be supplies goods or services, Receivables which the factoris prepared to purchase 00. a non -recourse basis are termed approved receiv-ables. These denote receivables arising from transactions specificallJy

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    The legal aspeas 565approved by thefac tor Or bJ]iH g w ith in a cred it l imit ~uthor i8ed by th e fa cto rto be given out to ill particul ar customer. Unapproved receivables in so. far aspurciulseci b} 1the facto, '!" are taken with reGOnrse: to. the. client if the relevantcustomers default.The fadm.ing agreem en t h as th e fo llow ing m ain contents :

    ]. An undertaking by the client to sell its accounts, receivables andagreement hy the factor to take the same. .2. The elient warrants thattbe debts are vaM, enforeeahle, undisputednod recoverable ,.Thisis to avoid the problems of disputes, damagesdeductions, etc . from bills, which i f and to d raw nego tiable instIllments i J ! 1 respect o f th e debts .8. Acceuntlng and admjnistrative m atters are aIso most ly set out foreonven ieaee .In respect ( l I f accounts which have already been assigned to the, factor,

    sometimes the customers p.ay dire,tly lO the elieat. Mos t factoring agree-ments cl.e

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    566 C hap. 2-C r~d it l-acto ring and B ill D isC Qun(ingor making him personally liable for the amount raised ..)I

    Thus, the factoring company is not hit by the prevision: of section 370and the client is not hit by section 58A Or 12.5of the Companies Act, 1956.

    u. OJ~ DSco .rmtCo . Lu i. v , J(Jh~ Playf fJ ir Ltd. (l9lR) 3 All E_R. 27S .