Raising short term and medium term debt by inviting and accepting deposits from the investing public has become an established practice with a large number of companies both in the private and public sectors. This is the outcome of the process of dis-intermediation that is taking place in Indian economy. Similarly, issuance of Commercial Paper by high net-worth Corporates enables them to raise short-term funds directly from investors at cheaper rates as compared to bank credit. In practice, however, commercial banks have been the major investors in Commercial Paper in India, implying thereby that bank credit flows to the corporate sector through the route of CPs. Inter-Corporate loans and investments enable the cash rich corporations to lend their surplus resources to those who need them for their working capital purpose. Factoring of receivables is a relatively recent innovation which enables corporates to convert their receivables into liquidity within a short period of time.
Factoring is an agreement under which the receivables arising out of the sale of goods/services are sold by a firm (called the client) to the factor (a financial intermediary), who becomes responsible for the collection of the receivable on the due date. Factoring of receivables is another source of raising working capital by a business entity. The factor thereafter becomes responsible for the collection of the receivables. In case of credit sale, the purchaser promises to pay the sale proceeds after a period of time. The seller has to wait for that period for realizing his claims from the buyer. His cash cycle is thus prolonged and he needs larger working capital. Factoring of receivables is a device to sell the receivables to a factor, which pays the whole or a major part of dues from the buyer immediately to the seller, thereby reducing his cash cycle and the requirements of working capital. The factor realizes the amount from the buyers on the due date.
Factoring business may be undertaken on ‘with recourse’ or ‘without recourse’ basis. Under with recourse factoring, the factor has recourse to the client if the receivable purchased turn out to be irrecoverable. In other words, the credit risk is borne by the client and not the factor. The factor is entitled to recover the amount from the client the amount paid in advance, interest for the period and any other expenses incurred by him. In short, when the factor bears the loss arising out of nonpayment of the dues by the buyer, it is called without recourse factoring. In case of ‘With Recourse Factoring’ he can recover the loss from the client (seller). In case of, without recourse factoring, the factor does not possess the above right of recourse. He has to bear the loss arising out of non-payment of dues by the buyer. The factor, therefore, charges higher commission for bearing this credit risk.
Mechanism of Factoring
- An agreement is entered into between the seller and the factor for rendering factoring services.
- After selling the goods to the buyer, the seller sends copy of invoice, delivery challan, instructions to make payment to the factor, to the buyer and also to the factor.
- The factor makes payment of 80% or more of the amount of receivables to the seller.
- The seller should also execute a deed of assignment in favor of the factor to enable him to recover amount from the buyer.
- The seller should also obtain a letter of waiver from the banker in favor of the factor, if the bank has charge over the asset sold to the buyer.
- The seller should give a letter of confirmation that all conditions of the sale transactions have been completed.
- The seller should also confirm in writing that all payments receivable from the debtor are free from any encumbrances, charge, right of set off or counter claim from another person, etc.
- The facility of factoring in India is available to all forms of business organisations in manufacturing, service and trading. Sole proprietary concerns, partnership firms and companies can avail of the services of factors, but a ceiling on the credit which they can avail of in terms of the value of the invoice to be purchased is generally fixed for each client in medium and small scale sectors. Generally the period for which receivables are factored ranges between 30 and 90 days.
- The factor evaluates the client on the basis of various criteria e.g. level of receivables turnover, the quality of receivables, growth in sales, etc. The factor charges a service fee and a discount. The service fee is charged in advance and depends upon the invoice value for different categories of clients. It ranges between 0.5-0.2% of the invoice value.
Moreover, the factor also charges a discount on the pre-payment made to the client. It is payable in arrears and is generally linked to the bank lending rate. In case of high worth clients, the discount rate is presently one percent point lower than the rate charged under the cash credit system. The cost of funds under, without recourse, factoring is much higher than with recourse, factoring due to the credit risk borne by the factor. However, the service fee and discount charge depends upon the cost of funds and the operational cost.