Factoring is a financial transaction whereby a business sells its accounts receivable

(i.e., invoices) to a third party (called a factor) at a discount in exchange for

immediate money with which to finance continued business. Factoring differs from a
bank loan in three main ways. First, the emphasis is on the value of the receivables
(essentially a financial asset)[1], not the firm’s credit worthiness. Secondly, factoring is
not a loan – it is the purchase of a financial asset (the receivable). Finally, a bank loan
involves two parties whereas factoring involves three.
It is different from the forfaiting in the sense that forfaiting is a transaction based
operation while factoring is a firm-based operation - meaning, in factoring, a firm
sells all its receivables while in forfaiting, the firm sells one of its transactions.

Factoring is a word often misused synonymously with invoice discounting[citation needed] -

factoring is the sale of receivables whereas invoice discounting is borrowing where
the receivable is used as collateral.
The three parties directly involved are: the one who sells the receivable, the debtor,
and the factor. The receivable is essentially a financial asset associated with the
debtor’s liability to pay money owed to the seller (usually for work performed or
goods sold). The seller then sells one or more of its invoices (the receivables) at a
discount to the third party, the specialized financial organization (aka the factor), to
obtain cash. The sale of the receivables essentially transfers ownership of the
receivables to the factor, indicating the factor obtains all of the rights and risks
associated with the receivables.[2] Accordingly, the factor obtains the right to receive
the payments made by the debtor for the invoice amount and must bear the loss if
the debtor does not pay the invoice amount. Usually, the account debtor is notified of
the sale of the receivable, and the factor bills the debtor and makes all collections.
Critical to the factoring transaction, the seller should never collect the payments
made by the account debtor, otherwise the seller could potentially risk further
advances from the factor. There are three principal parts to the factoring transaction;
a.) the advance, a percentage of the invoice face value that is paid to the seller upon
submission, b.) the reserve, the remainder of the total invoice amount held until the
payment by the account debtor is made and c.) the fee, the cost associated with the
transaction which is deducted from the reserve prior to it being paid back the seller.
Sometimes the factor charges the seller a service charge, as well as interest based
on how long the factor must wait to receive payments from the debtor. [3] The factor
also estimates the amount that may not be collected due to non-payment, and
makes accommodation for this when determining the amount that will be given to
the seller. The factor's overall profit is the difference between the price it paid for the
invoice and the money received from the debtor, less the amount lost due to non-
payment.[2]
American Accounting considers the receivables sold when the buyer has "no
recourse"[4], or when the financial transaction is substantially a transfer of all of the
rights associated with the receivables and the seller's monetary Liability under any
"recourse" provision is well established at the time of the sale.[5] Otherwise, the
financial transaction is treated as a loan, with the receivables used as collateral.
Contents
[hide]
1 Reason
2 Differences from bank
loans
3 Invoice sellers
4 Factors
5 Invoice payers (debtors)
6 Risks
7 History
8 See also
9 External links
10 References
Reason
Factoring is a method used by a firm to obtain Cash when the available Cash Balance
held by the firm is insufficient to meet current obligations and accommodate its other
cash needs, such as new orders or contracts. The use of Factoring to obtain the Cash
needed to accommodate the firm’s immediate Cash needs will allow the firm to
maintain a smaller ongoing Cash Balance. By reducing the size of its Cash Balances,
more money is made available for investment in the firm’s growth. A company sells
its invoices at a discount to their face value when it calculates that it will be better off
using the proceeds to bolster its own growth than it would be by effectively
functioning as its "customer's bank." Accordingly, Factoring occurs when the rate of
return on the proceeds invested in production exceed the costs associated with
Factoring the Receivables. Therefore, the trade off between the return the firm earns
on investment in production and the cost of utilizing a Factor is crucial in determining
both the extent Factoring is used and the quantity of Cash the firm holds on hand.
Many businesses have Cash Flow that varies. A business might have a relatively large
Cash Flow in one period, and might have a relatively small Cash Flow in another
period. Because of this, firms find it necessary to both maintain a Cash Balance on
hand, and to use such methods as Factoring, in order to enable them to cover their
Short Term cash needs in those periods in which these needs exceed the Cash Flow.
Each business must then decide how much it wants to depend on Factoring to cover
short falls in Cash, and how large a Cash Balance it wants to maintain in order to
ensure it has enough Cash on hand during periods of low Cash Flow.
Generally, the variability in the cash flow will determine the size of the Cash Balance
a business will tend to hold as well as the extent it may have to depend on such
financial mechanisms as Factoring. Cash flow variability is directly related to 2
factors:
The extent Cash Flow can change,
The length of time Cash Flow can remain at a below average level.
If cash flow can decrease drastically, the business will find it needs large amounts of
cash from either existing Cash Balances or from a Factor to cover its obligations
during this period of time. Likewise, the longer a relatively low cash flow can last, the
more cash is needed from another source (Cash Balances or a Factor) to cover its
obligations during this time. As indicated, the business must balance the opportunity
cost of losing a return on the Cash that it could otherwise invest, against the costs
associated with the use of Factoring.
The Cash Balance a business holds is essentially a Demand for Transactions Money.
As stated, the size of the Cash Balance the firm decides to hold is directly related to
its unwillingness to pay the costs necessary to use a Factor to finance its short term
cash needs. The problem faced by the business in deciding the size of the Cash
Balance it wants to maintain on hand is similar to the decision it faces when it
decides how much physical inventory it should maintain. In this situation, the
business must balance the cost of obtaining cash proceeds from a Factor against the
opportunity cost of the losing the Rate of Return it earns on investment within its
business[6]. The solution to the problem is:

[7]

where
CB is the Cash Balance
nCF is the average Negative Cash Flow in a given period
i is the [Discount Rate] that cover the Factoring Costs
r is the rate of return on the firm’s assets[8]
Differences from bank loans
Factors make funds available, even when banks would not do so, because factors
focus first on the credit worthiness of the debtor, the party who is obligated to pay
the invoices for goods or services delivered by the seller. In contrast, the
fundamental emphasis in a bank lending relationship is on the creditworthiness of the
borrower, not that of its customers. While bank lending is cheaper than factoring, the
key terms and conditions under which the small firm must operate differ significantly.
From a combined cost and availability of funds and services perspective, factoring
creates wealth for some but not all small businesses. For small businesses, their
choice is slowing their growth or the use of external funds beyond the banks. In
choosing to use external funds beyond the banks the rapidly growing firm’s choice is
between seeking venture capital (i.e., equity) or the lower cost of selling invoices to
finance their growth. The latter is also easier to access and can be obtained in a
matter of a week or two, whereas securing funds from venture capitalists can
typically take up to six months. Factoring is also used as bridge financing while the
firm pursues venture capital and in conjunction with venture capital to provide a
lower average cost of funds than equity financing alone. Firms can also combine the
three types of financing, angel/venture, factoring and bank line of credit to further
reduce their total cost of funds whilst at the same time improving cash flow.
As with any technique, factoring solves some problems but not all. Businesses with a
small spread between the revenue from a sale and the cost of a sale, should limit
their use of factoring to sales above their breakeven sales level where the revenue
less the direct cost of the sale plus the cost of factoring is positive.
While factoring is an attractive alternative to raising equity for small innovative fast-
growing firms, the same financial technique can be used to turn around a
fundamentally good business whose management has encountered a perfect storm
or made significant business mistakes which have made it impossible for the firm to
work within the constraints of their bank covenants. The value of using factoring for
this purpose is that it provides management time to implement the changes required
to turn the business around. The firm is paying to have the option of a future the
owners control. The association of factoring with troubled situations accounts for the
half truth of it being labeled 'last resort' financing. However, use of the technique
when there is only a modest spread between the revenue from a sale and its cost is
not advisable for turnarounds. Nor are turnarounds usually able to recreate wealth
for the owners in this situation.
Large firms use the technique without any negative connotations to show cash on
their balance sheet rather than an account receivable entry, money owed from their
customers, particularly when these show payments being due for extended periods
of time beyond the North American norm of 60 days or less.
Invoice sellers
The invoice seller presents recently generated invoices to the factor in exchange for
an amount that is less than the value of the invoice(s) by an agreed upon discount
and a reserve. A reserve is a provision to cover short payments, payment of less than
the full amount of the invoice by the debtor, or a payment received later than
expected. The result is an initial payment followed by a second one equal to the
amount of the reserve if the invoice is paid in full and on time or a credit to the
account of the seller with the factor. In an ongoing relationship the invoice seller will
get their funds one or two days after the factor receives the invoices. Astute invoice
sellers can use a combination of techniques to cover the range of 1% to 5% plus cost
of factoring for invoices paid within 50 to 60 days or more. In many industries,
customers expect to pay a few percentage points higher to get flexible sales terms.
In effect the customer is willing to pay the supplier to be their bank and reduce the
equity the customer needs to run their business. To counter this it is a widespread
practice to offer a prompt payment discount on the invoice. This is commonly set out
on an invoice as an offer of a 2% discount for payment in ten days. {Few firms can be
relied upon to systematically take the discount, particularly for low value invoices -
under $100,000 - so cash inflow estimates are highly variable and thus not a reliable
basis upon which to make commitments.} Invoice sellers can also seek a cash
discount from a supplier of 2 % up to 10% (depending on the industry standard) in
return for prompt payment. Large firms also use the technique of factoring at the end
of reporting periods to ‘dress’ their balance sheet by showing cash instead of
accounts receivable. There are a number of varieties of factoring arrangements
offered to invoice sellers depending upon their specific requirements. The basic ones
are described under the heading Factors below.
Factors
When initially contacted by a prospective invoice seller, the factor first establishes
whether or not a basic condition exists, does the potential debtor(s) have a history of
paying their bills on time? That is, are they creditworthy? (A factor may actually
obtain insurance against the debtor’s becoming bankrupt and thus the invoice not
being paid.) The factor is willing to consider purchasing invoices from all the invoice
seller’s creditworthy debtors. The classic arrangement which suits most small firms,
particularly new ones, is full service factoring where the debtor is notified to pay the
factor (notification) who also takes responsibility for collection of payments from the
debtor and the risk of the debtor not paying in the event the debtor becomes
insolvent, non recourse factoring. This traditional method of factoring puts the risk of
non-payment fully on the factor. If the debtor cannot pay the invoice due to
insolvency, it is the factor's problem to deal with and the factor cannot seek payment
from the seller. The factor will only purchase solid credit worthy invoices and often
turns away average credit quality customers. The cost is typically higher with this
factoring process because the factor assumes a greater risk and provides credit
checking and payment collection services as part of the overall package. For firms
with formal management structures such as a Board of Directors (with outside
members), and a Controller (with a professional designation), debtors may not be
notified (i.e., non-notification factoring). The invoice seller may not retain the credit
control function. If they do then it is likely that the factor will insist on recourse
against the seller if the invoice is not paid after an agreed upon elapse of time,
typically 60 or 90 days. In the event of non-payment by the customer, the seller must
buy back the invoice with another credit worthy invoice. Recourse factoring is
typically the lowest cost for the seller because they retain the bad debt risk, which
makes the arrangement less risky for the factor.
Despite the fact that most large organizations have in place processes to deal with
suppliers who use third party financing arrangements incorporating direct contact
with them, many entrepreneurs remain very concerned about notification of their
clients. It is a part of the invoice selling process that benefits from salesmanship on
the part of the factor and their client in its conduct. Even so, in some industries there
is a perception that a business that factors its debts is in financial distress.
There are two methods of factoring: recourse and non-recourse. Under recourse
factoring, the client is not protected against the risk of bad debts. On the other hand,
the factor assumes the entire credit risk under non-recourse factoring i.e., full
amount of invoice is paid to the client in the event of the debt becoming bad.
Invoice payers (debtors)
Large firms and organizations such as governments usually have specialized
processes to deal with one aspect of factoring, redirection of payment to the factor
following receipt of notification from the third party (i.e., the factor) to whom they will
make the payment. Many but not all in such organizations are knowledgeable about
the use of factoring by small firms and clearly distinguish between its use by small
rapidly growing firms and turnarounds.
Distinguishing between assignment of the responsibility to perform the work and the
assignment of funds to the factor is central to the customer/debtor’s processes. Firms
have purchased from a supplier for a reason and thus insist on that firm fulfilling the
work commitment. Once the work has been performed however, it is a matter of
indifference who is paid. For example, General Electric has clear processes to be
followed which distinguish between their work and payment sensitivities. Contracts
direct with US Government require an Assignment of Claims which is an amendment
to the contract allowing for payments to third parties (factors).
Risks
The most important risks of a factor are:
Counter party credit risk related to clients and risk covered debtors. Risk covered
debtors can be reinsured, which limit the risks of a factor. Trade receivables are a
fairly low risk asset due to their short duration.
External fraud by clients: fake invoicing, mis-directed payments, pre-invoicing, not
assigned credit notes, etc. A fraud insurance policy and subjecting the client to audit
could limit the risks.
Legal, compliance and tax risks: large number of applicable laws and regulations in
different countries.
Operational risks, such as contractual disputes.
Uniform Commercial Code (UCC-1) securing rights to assets.
IRS liens associated with payroll taxes etc.
ICT risks: complicated, integrated factoring system, extensive data exchange with
client.
History
Factoring's origins lie in the financing of trade, particularly international trade.
Factoring as a fact of business life was underway in England prior to 1400.[9] It
appears to be closely related to early merchant banking activities. The latter however
evolved by extension to non-trade related financing such as sovereign debt.[10] Like
all financial instruments, factoring evolved over centuries. This was driven by
changes in the organization of companies; technology, particularly air travel and non-
face to face communications technologies starting with the telegraph, followed by
the telephone and then computers. These also drove and were driven by
modifications of the common law framework in England and the United States.[11]
Governments were latecomers to the facilitation of trade financed by factors. English
common law originally held that unless the debtor was notified, the assignment
between the seller of invoices and the factor was not valid. The Canadian Federal
Government legislation governing the assignment of moneys owed by it still reflects
this stance as does provincial government legislation modelled after it. As late as the
current century the courts have heard arguments that without notification of the
debtor the assignment was not valid. In the United States it was only in 1949 that the
majority of state governments had adopted a rule that the debtor did not have to be
notified thus opening up the possibility of non-notification factoring arrangements.[12]
Originally the industry took physical possession of the goods, provided cash
advances to the producer, financed the credit extended to the buyer and insured the
credit strength of the buyer.[13] In England the control over the trade thus obtained
resulted in an Act of Parliament in 1696 to mitigate the monopoly power of the
factors.[13] With the development of larger firms who built their own sales forces,
distribution channels, and knowledge of the financial strength of their customers, the
needs for factoring services were reshaped and the industry became more
specialized.
By the twentieth century in the United States factoring became the predominant
form of financing working capital for the then high growth rate textile industry. In
part this occurred because of the structure of the US banking system with its myriad
of small banks and consequent limitations on the amount that could be advanced
prudently by any one of them to a firm.[14] In Canada, with its national banks the
limitations were far less restrictive and thus factoring did not develop as widely as in
the US. Even then factoring also became the dominant form of financing in the
Canadian textile industry.
Today factoring's rationale still includes the financial task of advancing funds to
smaller rapidly growing firms who sell to larger more creditworthy organizations.
While almost never taking possession of the goods sold, factors offer various
combinations of money and supportive services when advancing funds.
Factors often provide their clients four key services: information on the
creditworthiness of their prospective customers domestic and international; maintain
the history of payments by customers (i.e., accounts receivable ledger); daily
management reports on collections; and, make the actual collection calls. The
outsourced credit function both extends the small firms effective addressable
marketplace and insulates it from the survival-threatening destructive impact of a
bankruptcy or financial difficulty of a major customer. A second key service is the
operation of the accounts receivable function. The services eliminate the need and
cost for permanent skilled staff found within large firms. Although today even they
are oursourcing such backoffice functions. More importantly, the services insure the
entrepreneurs and owners against a major source of a liquidity crises and their
equity.
In the latter half of the twentieth century the introduction of computers eased the
accounting burdens of factors and then small firms. The same occurred for their
ability to obtain information about debtor’s creditworthiness. Introduction of the
Internet and the web has accelerated the process while reducing costs. Today credit
information and insurance coverage is available any time of the day or night on-line.
The web has also made it possible for factors and their clients to collaborate in
realtime on collections. Acceptance of signed documents provided by facsimile as
being legally binding has eliminated the need for physical delivery of “originals”,
thereby reducing time delays for entrepreneurs.
By the first decade of the twenty first century a basic public policy rationale for
factoring remains that the product is well suited to the demands of innovative rapidly
growing firms critical to economic growth.[15] A second public policy rationale is
allowing fundamentally good business to be spared the costly management time
consuming trials and tribulations of bankruptcy protection for suppliers, employees
and customers or to provide a source of funds during the process of restructuring the
firm so that it can survive and grow.
Walter E. Heller was a pioneer on the use of factoring in the United States[16][17][18]

Factoring is a financial service designed to help firms to arrange their receivable

better. Under a typical factoring arrangement a factor collects the accounts on due
dates, effects payments to the firm on these dates and also assumes the credit risks
associated with the collection of the accounts.
Sometimes the factor provides an advance against the values of receivable taken
over by it. In such cases factoring serves as a source of short-term finance for the
firm.
In order to provide a gamut of financial services under one roof, Corporation has also
started factoring services. Under the scheme Corporation shall be at the time being
only providing advances or prepayments against receivable and other services
provided by the factor such as debt collection and administration of sales ledger etc.
shall be taken later on.
Under the scheme receivables only arising out of domestic trade shall be considered
for factoring. Supplier/Borrower shall draw bills of exchange for goods supplied and
the purchaser shall accept that. After acceptance of bills of exchange, Corporation
shall make prepayment of 80% of invoice value after deducting its discount charges
@ 17% to 18% p.a. for period of bill of exchange to supplier. Balance payment of
20% of the invoice value shall be made after collecting the payment from purchaser.
If purchaser fails to pay the due amount on due dates, the supplier shall make the
payment. Borrower/ Supplier shall submit Bill of Exchange alongwith invoice LR/RR
receipts. Suppliers to be eligible for factoring must have minimum track record of 03
years with consistent profitability and minimum net worth of Rs. 25.00 lacs.
Usually before providing advance payments to supplier an agreement is entered with
supplier for arising debts of purchaser to Corporation and Corporation make
advances only against invoices drawn to this particular purchaser. Sub-limit of each
purchaser is fixed and sum of these sub limits is over all limit of supplier. Usually
purchaser should have been dealing with supplier for minimum period of two years.
Maximum limit of each purchaser should not exceed Rs. 25.00 Lacs at a time.
Usually limit for factoring is calculated on the basis of the projected receivables on
credit sales of the company and deducting existing bills/books debts limits enjoyed
by the company from bank. Maximum limit shall not exceed two months average
turnover of the supplier as per last audited balance sheet or projected turnover of
current year subject to maximum of Rs. 100.00 Lacs.