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FACTORING

(Topic – 1)

1.1: Definition of Factoring: A Factor is a financial institution which offers services relating to management and
financing of debts arising from credit sales. The service provided by the factors is known as Factoring.

1.2: Types of Factoring: The factoring services can broadly be classified into four main groups:

a) Non-Recourse Factoring: Under this method , book debts are purchased by the factor , assuming
100% credit risks i.e. the full amount of invoices have to be paid to clients in the event of debt
becoming debt. The client is protected against bad debts.
b) Recourse Factoring: Under this method , the client is not protected against the risk of bad debts. If
the factor has advanced funds against book debts on which a customer subsequently defaults , the
client will have to refund the money.
c) Bulk/Agency Factoring: This type of factoring is basically used as a method of financing book debts.
The client continues to administer credit and operate sales ledger. Those companies which have
good system of credit management but need finances prefer this type of factoring.
d) Non-Notification Factoring: In this type of factoring , customers are not informed about the factoring
agreement. It involves the factor keeping the account ledger in the name of the sales company to
which the client sell his book debts. The factor performs all his usual functions without a disclosure to
customer that he owns the book debts.

1.3: Costs and Benefits of Factoring: From the point of view of the client there are two types of costs involved:

 Factoring Commission or Service Fee. It is paid for credit evaluation and collection and other
services and to cover bad debt losses. The amount of commission will depend on the total volume of
receivables and quality of receivables. The commission is expected to be higher for without recourse
factoring than the with recourse factoring.
 Interest on advance granted by the factor to the firm.

Following benefit may be obtained from factoring:

 Reduction of cost in collecting department


 Reduction the bad debt loss

1.4: Important Points to be Kept in Mind:

 Factoring Commission is to be calculated on the receivables covered under factoring unless


otherwise mentioned.
 Gross advance is amount of receivables covered under factoring minus reserve , if any.
 Net advance is Gross Advance minus up font interest on advance , if any , minus up front
commission , if any.
 Rate of interest is to be applied always on Gross Advance.
 For interest calculation time period is the age of the receivables.

Illustration-1.1: A small firm has a total credit sales of Rs.80 lakhs and its average collection period is 80 days.
The past experience indicates that bad debt losses are around 1% of credit sales. The firm spends about
Rs.1,20,000 per annum on administering its credit sales. The cost includes salaries of one officer and two clerks
who handle credit checking , collection etc. , telephone and telex charges. These are avoidable costs. A factor is
prepared to buy the firm’s receivables. He will charge 2% commission. He will also pay advance against
receivables to the firm at an interest rate of 18% after withholding 10% as reserve.
a) Determine advance payable by the factor to the firm.
b) Determine the cost of factoring.
Assume 360 days year.

Solution:
1. Average Receivables = Rs.80,00,000 X 80 / 360 = Rs.17,77,778
2. Factoring commission = Rs.17,77,778 X 2% = Rs.35,556
3. Reserve = 10% of receivables = Rs.17,77,778 X 10% = Rs.1,77,778
4. Advance ( Gross ) payable by the factor = Rs.(17,77,778 – 1,77,778) = Rs.16,00,000
5. Interest Chargeable = Rs.16,00,000 X 18% X 80 / 360 = Rs.64,000
Now , there may be four different cases. Each of them is discussed below :-

CASE – 1: Interest and commission are to be paid up front :-


a) Advance ( net ) payable by the factor = Rs.( 16,00,000 – 35,556 – 64,000 ) = Rs.15,00,444
b) Cost of Factoring for 80 days = Commission + Interest = Rs.(35,556 + 64,000) = Rs.99,556
c) Annualized cost of factoring = Rs.99,556 X 360 / 80 = Rs.4,48,002
d) Cost saving due to factoring = Saving of Bad Debt + Saving of Administrative Cost = Rs.1,20,000 + Rs.80,000
= Rs.2,00,000
e) Net Cost of Factoring = Rs.( 4,48,002 – 2,00,000 ) = Rs.2,48,002
f) Effective Annualized Rate of Cost = 2,48,002 / 15,00,444 = 0.1653 or 16.53%

CASE – 2: No up front payment with respect to Interest as well as commission :-


a) Advance ( net ) payable by the factor = Rs.16,00,000
b) Cost of Factoring for 80 days = Commission + Interest = Rs.(35,556 + 64,000) = Rs.99,556
c) Annualized cost of factoring = Rs.99,556 X 360 / 80 = Rs.4,48,002
d) Cost saving due to factoring = Saving of Bad Debt + Saving of Administrative Cost = Rs.1,20,000 + Rs.80,000
= Rs.2,00,000
e) Net Cost of Factoring = Rs.( 4,48,002 – 2,00,000 ) = Rs.2,48,002
f) Effective Annualized Rate of Cost = 2,48,002 / 16,00,000 = 0.1550 or 15.50%

CASE – 3: Only commission is up front :-


a) Advance ( net ) payable by the factor = Rs. ( 16,00,000 – 35,556 ) = Rs.15,64,444
b) Effective Annualized Rate of Cost = 2,48,002 / 15,64,444 = 0.1585 or 15.85%

CASE – 4: Only interest is up front :-


a) Advance ( net ) payable by the factor = Rs.( 16,00,000 – 64,000 ) = Rs.15,36,000
b) Effective Annualized Rate of Cost = 2,48,002 / 15,36,000 = 0.1615 or 16.15%

1.5: Advantages and Disadvantages of Factoring: Following are the advantages of factoring:
a) As the job is done by experts , collection of debt is quick and the amount of bad debt is less.
b) Management can spend more time for other important activities of the business , as a result the
efficiency of the business is increased.
Following are the disadvantages of factoring:
a) The cost of factoring is normally higher than the short term borrowing
b) Factoring of debt may be perceived as a sign of financial weakness.