What is Factoring?
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), 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.
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. 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.
Factoring may be defined as “A contract by which the factor is to provide at least two of the services, (finance, the maintenance of accounts, the collection of receivables and protection against credit risks) and the supplier is to assigned to the factor on a continuing basis by way of sale or security, receivables arising from the sale of goods or supply of services”.
Unlike a traditional loan, factoring does not put debt on balance sheet and there are no loans to repay. By selling accounts receivable to a Factor rather than borrowing from a Bank, factoring simply converts one asset, the accounts receivable, into another asset, cash. Factoring of accounts receivable helps to improve the cash flow or in addition to existing financing. There are no lengthy applications or loan committees, and no financial audit is requested. With Factoring, there’s no need for credit or collection departments, and no need to spend your profits on maintaining accounts receivables. Factoring can be short term or part of an ongoing financing program. Factoring offers smaller companies the instant cash advantage that was once available only to large companies with high sales volumes. New companies can benefit as well since there is no requirement for a long-term credit history.
Under Export Factoring the factoring of export invoices drawn on overseas buyers and prepay to clients an agreed percentage of the invoice value immediately. Under two-factor system, the factor handling the collection of export receivables of clients (exporters) is called Export Factor (EF) and the factor in buyer’s country who undertake collection and credit protection services is called Import factor.
The following steps are involved:
- The exporter ships the goods to importer.
- The exporter assigns his invoices through the export factor to the import factor who assumes the credit risk. (as per prior arrangement).
- The Export factor prepays invoices.
- The importer pays the proceeds to the Import factor, who transfers the amount to Export factor.
- The export factor deducts prepayment already made, other charges and pays the balance proceeds to the exporter.
Benefits to Exporters
The import factor offers credit risk protection in case buyer does not pay invoices within 90 days of due date.
- ECGC policy cost can be saved. There is reduction is administrative cost as the exporter will be dealing with only one Export Factor irrespective of the number of countries involved.
- The exporter can obtain valuable information on the standing of the foreign buyers on trade customs and market potential in order to expand his business.
- The following up of receivables by import factor will speed up the collections.
- Factoring provide finance up to 90% on export invoices, the exporter has an improved cash flow and his liquidity improves markedly.
Benefits to Importer
- He can pay invoices in the country locally.
- He deals with the local agency, i.e. the Import Factor.
- Minimum documentation required.
- The cost of Letters of Credit and delay on account of LC’s are eliminated. All communication is in his own language.
Types of Export Factoring
Depending upon the need of the exporter-client and his price bearing capacity various types of international factoring are in vogue, the principal amongst them are:
1. Two Factor System
In this system, the transaction is based on operations of two factoring companies in two different countries involving four parties: i) exporter ii) importer iii) export factor in exporter’s country and iv) importer factor in importer’s country.
Various stages are:
- The exporter approaches the export factor with various business information which inter alia may include type of business, name and address of the debtors in various importing countries, annual expected turnover to each country, number of invoice/credit notes per country, payment term and line of credit requirement for each debtor.
- Based on the information furnished above, the export factor would contact his counterpart (import factor) in different countries to assess the credit worthiness of the various debtors.
- The import factor makes a preliminary assessment as to his ability to give credit cover to the principal debtors. If the assessment by the import factor is positive he would indicate the quantum of coverage coupled with required commission and other conditions for cooperation, otherwise the matter is referred back to export factor for alternatives.
- Agreement is signed between the exporter and the export factor. After shipment of goods by the exporter two copies of the invoice are sent to the export factor who then makes an agreed prepayment to the exporter and sends the invoice to the import factor.
- Import factor in turn collects the debts and remits the proceeds to export factor. In case if the payments are not received from any of the debtors at the end of agreed period (normally 90 days from the due date) the import factor has to pay the amount of the bill from out of his own resources. However this obligation will not apply in case of any disputes regarding quality, quantity terms and conditions of supply etc.
- Finally on receipt of the proceeds of the debts realized the balance held with the export factor (20 – 25%) will be released. Factoring fee will be debited to the exporters account and the export factor remits the mutually agreed commission to his importing counterpart.
Thus the main functions of the export factor relates to the assessment of the financial status of the exporter assessment of the financial status of the importer through import factor prepayment of the receivables to the exporter after proper documentation follow up of recovery with the import factor sharing commission with the import factor.
Correspondingly the import factor will be engaged in maintaining the details of sales to debtors in his country and collection of debts from the importers and remitting the proceeds to the export factor providing credit protection in case of financial inability by any of the debtors. Two factor system is probably the best mode of providing the most effective factoring facility to a prospective client.
2. Single Factoring System
With a view to obviating the constraints in the two-factor system single factoring system has been introduced. Under this system a special agreement is signed between two factoring companies in the exporting and importing countries on conditions for single factoring whereby as in the two factor system the credit cover is provided by the import factor. If the export factor is not in a position to realise any debt within 60 days from the due date he requests the importing counterpart to undertake the collection responsibility, simultaneously informing the defaulting debtor about the assignment of the debt to the latter. It is now the responsibility of the import factor to continue the collection efforts and initiate legal proceedings, if necessary. In case the debt remains outstanding for more than 90 days from the due date the import factor has to remit the amount by virtue of his credit risk undertaking to the export factor.
Pricing under this system is much lower compared to that of the two factor system. The variation is introduced upto the extent that the role of the import factor as a collection agency starts only if there is a potential threat of non-recovery. The import factor does not maintain any book of account of the exporter but acts on the information of the export factor. Thus in order to make the mechanism effective, a perfect coordination and co-operation bases on mutual trust and faith must exist between two factoring agencies.
3. Direct Export Factoring
Under this system only one factoring company is involved i.e., export factor, which provides all elements of service of factoring namely finance to exporter, maintenance of sales ledger and collection of debts from the importers, credit protection in case of financial inability on part of any of the importers. The basic advantage of this system is the obvious reduction in pricing structure coupled with uniform and quick service.
4. Direct Import Factoring
Under this system, the seller will choose to work directly with a factor in the importers country. The import factor is responsible for sales ledger, administration, collection of debts and providing bad debt protection under the agreed level of risk coverage. The disadvantage of the system is the lack of proximity between the exporter and the import factor, which may lead to problems at a later stage.