Factoring

Definition of Factoring

Factoring is a financial service in which the business entity sells its bill receivables to a third party at a discount in order to raise funds. It differs from invoice discounting. The concept of invoice discounting involves, getting the invoice discounted at a certain rate to get the funds, whereas the concept of factoring is broader. Factoring involves the selling of all the accounts receivable to an outside agency. Such agency is called a factor.

Concept of Factoring

The seller makes the sale of goods or services and generates invoices for the same. The business then sells all its invoices to a third party called the factor. The factor pays the seller, after deducting some discount on the invoice value. The rate of discount in factoring ranges from 2 to 6 percent. The factor does not make the payment of all invoices immediately to the seller. Rather, it pays only up to 75 to 80 percent of invoice value after deducting the discount. The remaining 20 to 25 percent of the invoice value is paid after the factor receives the payments from the seller’s customers.

Types of Factoring

FactoringThere are various types of factoring such as recourse and non-recourse, advance and maturity, full factoring, disclosed and undisclosed, domestic and cross-border.

Functions of Factor

The following are the functions performed by a factor:

  • Maintenance of Sales Ledger: Factor is responsible for maintaining the sales ledger of the client. So all the sales transactions of the client are taken care of by the factor.
  • Financing: The factor finances the client by purchasing all the account receivables.
  • Credit Protection: In the case of non-recourse factoring, the risk of non-payment or bad debts is on the factor.
  • Collection of Money: The factor performs the duty of collecting funds from the client’s debtors. This enables the client to focus on core areas of business instead of putting energies in the collection of money.

Factoring Process

The following steps are involved in the process of factoring:

  • The seller sells the goods to the buyer and raises the invoice on him.
  • The seller then submits the invoice to the factor for funding. The factor verifies the invoice.
  • After verification, the factor pays 75 to 80 percent to the client/seller.
  • The factor then waits for the customer to make the payment to him.
  • On receiving the payment from the customer, the factor pays the remaining 20 to 25 percent of the amount to the client after deducting his fee.

Advantages of Factoring

The following are the advantages:

  • It reduces the credit risk of the seller.
  • The working capital cycle runs smoothly as the factor immediately provides funds on the invoice.
  • Sales ledger maintenance by the factor leads to a reduction of cost.
  • Improves liquidity and cash flow in the organization.
  • It leads to improvement of cash in hand. This helps the business to pay its creditors in a timely manner which helps in negotiating better discount terms.
  • It reduces the need for the introduction of new capital in the business.

Disadvantages of Factoring

The following are the disadvantages:

  • Factor collecting the money on behalf of the company can lead to stress in the company and the client relationships.
  • The cost of factoring is very high.
  • Bad behavior of factor with the creditors can hamper the goodwill of the company.
  • Factors often avoid taking the responsibility for risky debtors. So the burden of managing such debtor is always in the company.

Conclusion

Thus, factoring forms an important part of a business, especially those businesses which are big in size. If used wisely and to the benefit of the company, it can help the business to grow significantly.

References:

Last updated on : January 20th, 2018
What’s your view on this? Share it in comments below.

Leave a Reply

Capital Employed
  • Lease Agreement and its Content
    Lease Agreement and its Content
  • Types of Mortgage
    Types of Mortgage
  • Shareholders Vs Stakeholders
    Shareholders Vs Stakeholders
  • Types of Debentures
    Types of Debentures
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Recent Posts

    Find us on Facebook


    Related pages


    capital infusion definitionstock price maximization definitiondisadvantages of idealismexamples of restrictive debt covenantsletter of credit worthinessm&m propositionpayback period techniqueeoq inventoryadvantages and disadvantages of equitystandby lc definitionwhat is gdr and adrtrade off theory of capital structuretrade debtorsdividend payout percentagehow to calculate the irrrevenue meaning in hindiconglomerate merger exampleslong lived asset impairmentarbitrage portfolio examplereceivable days ratio formulacapital rationingadvantages and disadvantages of stock marketno arbitrage pricing theorycalculate shareholder equitydifference between credits and debitssignificance of asset turnover ratiomanagement accounting variancesstable dividend policy would most commonly implycharacteristics of finance leasedividend discount formulahow do i calculate payback perioddupont financial analysiscurrent ratio versus quick ratiovariable growth model formulakinds of debentureinventories turnover perioddebtors turnover perioddebit and credit in accounting definitionspontaneous financing includesaccounts receivable collection period formulameaning of demeritsadvantages and disadvantages of dividend growth modeltotal credit sales formulalong lived tangible assetscalculate times interest earned ratiodebt to total assets ratio analysisshareholders equity equationexchange bill of ladingfinding wacccredit sales vs accounts receivabletrade credit advantages and disadvantagesinventoriable costs examplescapitalizing assetsirr defineddepreciation expense for tax purposeswacc valuationoverdraft current accountstock turnover days calculationassets turnover formulaadvantages and disadvantages of npv methodvshireis notes payable a debit or creditdefine cost behaviormacro environmental factorprofit maximization in financial managementamerican depository receipts adrdetermine payback periodtrade receivables turnover ratiowhat is the purpose of managerial accountingtrading velocity definitionformular for irrbearer debentures definitionmeaning of rocedisadvantages of debentureswhat are callable bondsadvantages and disadvantages of investment appraisaldebt equity ratio significance