Theory and Numericals

Types of factoring:

1. Recourse and Non Recourse Factoring

Recourse – receivables are sold to the factor with the understanding that all credit risks will be borne by
the firm (client) i.e. if the customer defaults in payment, the client have to make good the loss
incurred by the factor. (alternate way of recovering/collection of debt given by client to factor)
Non Recourse – Loss arising out of irrecoverable receivables is borne by the factor – for which he may
charge higher commission from the client as compensation (extra premium charged for bearing
the risk of irrecoverable loss is known as del credre commission)

2. Advance and Maturity Factoring

Advance - Factor pays 75-90% of the factored receivables in advance to the clients and the balance
amount is paid on collection/ guaranteed payment date after charging interest on the amount of
advance paid for the period between date of advance to date of actual collection from the
customers/ guaranteed payment date
Maturity factoring also known as collection factoring – factor does not make any pre payment. Payment
is made to the client by the factor on the guaranteed payment date or date of collection from
the customer.
Bank Participation Factoring – Extension of advance factoring under which bank provides (i) advance to
the client to finance part of balance factor reserve. For example, if a client enters into an
agreement with a factor for 75% of the receivables as advance, and bank gives advance of 50%,
then the client will be receiving 75% advance from factor + 50% of balance i.e. 50% of 25% i.e.
12.5 % from bank = 87.5% as advance (ii) factor arranges advance to the clients though the
banker. Net factor Advance will be equal to Factor Advance % x Bank Advance %.

3. Disclosed and Undisclosed Factoring

Disclosed – name of factor is disclosed in the invoice by the supplier of goods asking the buyer to make
payment to the factor.
Undisclosed – name of factor is not disclosed in the invoice, however factor still maintains the sales
ledger of the supplier.
4. Domestic and Export/International/Cross Border Factoring
Domestic – 3 parties namely buyer, supplier and factor domiciled in the same country
Cross Border – also known as ​2 factors system of factoring since 2 factors are involved - 4 parties
namely exporter (client), importer (customer), export factor and import factor belong to
different countries.
5. Full factoring – also known as old line factoring – combining features of almost all the factoring
services specially non recourse and advance – providing the entire spectrum of services.

Two Factor Systems of Factoring

 International factoring involves two factors in the deal, and hence is known as two factor system of
factoring. It results in 2 separate but interlinked agreements:

(i) Between Exporter (Client) and Export Factor

(ii) Between Export Factor and Import Factor

The import factor

● is a link between importer and export factor.
● Solves international barriers such as language, legal formalities etc
● Underwrites customer trade credit risks,
● collects receivables and transfers funds to export factor

Process

Read about Legal Aspects of Factoring, Factoring Regulation Act from MY Khan

Methods of Evaluation of Factoring

1. Net benefit method – The desirability of factoring is determined on the basis of net benefit
accruing from it. Net Benefit = Expected benefits – Expected Costs
2. Effective Rate of Interest Method – that would be incurred due to factoring by the firm.
ERI = Net Factoring Cost/ Net Factor Advance

Steps in Evaluation
 1. Calculate average level of accounts receivables factored = Net total credit sales x Average Credit
Period ÷ 360 x %Factored (AF = Sales x F% x ACP÷ 360)
2. Calculate Factoring Commission = Net Total Credit Sales x Factoring Commission% x ACP ÷ 360
(FC = Cr Sales x FC% ) or Average Level of Accounts Receivable x Factoring Commission%
3. Calculate Factor Reserve = Average Level of Accounts Receivable Factored x Reserve% (FR = AF x
R%)
4. Calculate Gross Factor Advance Available = Average Level of Accounts Receivable Factored –
Factoring Commission – Factor reserve (GFAD = AF – FR – FC)
5. Calculate Interest/ Discount on Factoring = Gross Factor Advance x Interest/Discount% x
Average Credit Period ÷ 360 (IntF = GFAD x Int % x ACP ÷ 360)
6. Calculate Net Factor Advance = Gross Factor Advance – Interest/ Discount on Factoring (NFAD =
GFAD – IntF)
7. Calculate ​Total Direct Factoring Costs = Factoring Commission + Interest/Discount on Factoring
(TFC = FC + IntF)
8. Calculate own funds invested in Receivables = Total Credit Sales – Net Factoring Advance
9. Calculate In house credit management costs
10. Calculate Bad loss avoided (if any)
11. Benefits of Factoring​ = Inhouse Credit Management Cost + Bad Debt Loss
12. I. Net Cost of Factoring = ​Benefits – Costs
II. Effective Rate of Interest = ​Net Cost of Factoring ÷ Gross Factoring Advance
13. Find cost of alternative source of short term finance = Gross factoring Advance x Rate of Interest

If effective rate of interest < Normal Interest Rate, Factoring is favourable

If ERI > r, factoring is not a good option

Please Note:
If the factor collects commission and interest at the end of each cycle, the base for interest would be
the advance amount of factored receivable in each cycle. If any of these or both are
collected in advance, the relevant amount will be deducted for calculation as the amount is
collected in advance and hence no interest is due on the same

Numericals:

1. HML enters into a factoring arrangement with HFL. According to the agreement, HFL would pay
80% of the value of the factored receivable in advance at 25% interest compounded quarterly,
the balance retained as factor reserve to disputes and deductions. It also provides for
guaranteed payment after 2 months from the date of purchase of receivables. The factoring
commission would be 2 % of the value of the factored receivables. It is stipulated that interest
and commission would be collected in advance. Assuming the advance payment of Rs 42 lacs,
compute:
(i) Advance payable to HML
(ii) Effective cost of funds ​(please note the quest is not asking effective cost of factoring)
 (iii) With an assumption that interest is collected in arrears while the commission is
collected in advance, calculate effective cost of funds

Solution:
(i) Calculation of Advance Funds
Since HFL would pay 80% of the value of the factored receivable in advance and that advance
payment is of Rs 42 lacs, total value of factored receivables be
80% of total FR = 42 L
Total FR = 42L÷ 80% = 52.50 L
Amount of FR as advance = 42 L
Less: Commission @2% of total FR = 52.5 x 2% = 1.05L
Less: Discount/ Interest Charge @25% pa compounded quarterly = 42 x 25 % x 90÷360 = 2.625 L
Advance Funds to HML = 42- 1.05 – 2.625 = Rs ​38.325L
(ii) Effective Cost of Funds
Amount of FR as advance less of commission charges = 42L – 1.05 L = 40.95L
Amount of Interest charged = Rs 2.625L
Effective cost of funds per quarter = 2.625÷ 40.95 = ​6.41%
Effective cost of funds pa = (1 + 0.0641)​4 ​-1 = 28.21%
(iii) Effective Cost of Funds
Amount of FR as advance less of commission charges = 42L – 2% of 42L = 42 – 0.84 = 41.16
Amount of Interest charged = Rs 2.625L
Effective cost of funds per quarter = 2.625÷ 41.16 = ​6.38%
Effective cost of funds pa = (1 + 0.0638)​4 ​-1 = 28.07%

2. The annual credit sales of X Ltd were Rs 48,00,000. The company offers 3 months credit to its
customers. Currently the bad debt losses are 2% of total credit sales. The company appoints a
factor who would collect the receivables at fees of 5% on a non recourse basis. It is expected
that the administrative and collection cost of X Ltd will be reduced by Rs 8000 per month. The
factor also agrees to advance to the company by charging interest of 15% pa. The factor would
maintain a reserve of 25% on the debtors balance for providing such advance. Assume that
interest and commission are paid to the factor at the end of each cycle. Determine effective cost
of factoring.
Solution:
Since it is non recourse arrangement, factor will bear the bad debt loss. In other words, benefit of
factoring will be saving the loss of bad debt
Overall credit Sales =Rs 48,00,000
At a given point of time, average debtor/receivable = 48L x 3 ÷12 =Rs 12,00,000
Less: Factor Reserve = 25% of Receivable = 25% x 12,00,000 = Rs 3,00,000
Net Advance to X Ltd. = Rs 9,00,000
Interest on Advance = 9,00,000 x 15% = Rs 1,35,000 (Overall annual interest)
Factoring Fees = 12L x 4 or 48L x 5% = Rs 2,40,000
Cost of factoring for the year = 1.35 + 2.40 = Rs 3,75,000
Benefits
 Savings in Bad Debt = 48,00,000 x 2% = 96,000
Collection Cost Saving = 8000 x 12 = 96000
Total benefits = Rs 1,92,000
Net Annual Cost of Factoring = 3.75- 1.92 = Rs 1,83,000
Effective cost of factoring = 1.83 ÷ 9 = 20.33%
Though 183000 is annual cost and 900000 is calculation of each cycle. Explanation to that is for each
cycle cost is Rs 183000/4 and hence effective cost of each cycle will be 45750/900000x 100 =
5.0833%. Hence annual effective rate = 5.083 x 4 = 20.332%
Note: Both the amounts are collected at the end, hence entire advance amount is chargeable for
effective rate.
3. RIL is presently managing its accounts receivables internally by sales and credit department. Its
credit terms for sales are 2/10 net, 30. The past experience of RIL has been that on an average
30% of the customers’ avail of the discount, while the balance of the receivables is collected on
an average 60 days after the invoice date. Further, 2% of the sales turnover results into bad
debts.
The firm is financing its investments in receivables through a mix of bank finance and long term finance
in the ratio of 2:1. The effective rate of interest on bank finance is 22% and the cost of own
funds is 30%.
The projected sales for the next year is Rs 500 lacs. The credit and collection department spends on an
average 1/4​th​ of its time on collection of receivables.
A proposal to avail of factoring service from FFL as an alternative to in- house management of
receivables collection and credit monitoring is under the consideration of the BOD of the RIL. If
the proposal, details of which are given below, is accepted it is expected that the projected sales
for the next year can increase by Rs 50 lacs as a result of the diversion of the time of the
executives of the sales, credits and collection department to sales promotion. For the type of
product that RIL is producing, the gross margin on sales in the past has been 20%. Moreover,
there would be a saving in administrative overheads amounting to Rs 2.5 lacs due to
discontinuance of sales ledger administration and credit monitoring.
According to the factoring proposal, the FFL offers a guaranteed payment of 30 days. The other details
are listed below:
The FFL would advance 80% and 85% in case of recourse and non recourse factoring deal respectively,
the balance would be retained as factor reserve. The discount charge in advance (up- front)
would be 22% for recourse type and 21 % for non recourse type of service. The FFL would also
charge a commission @2% (recourse) and 4% (non recourse). The commission is payable
upfront.
Before taking a decision on the proposal, the Board seeks your advice, as a financial consultant, on the
course of action. What advice would you give? Why?

Solution:
Notes:
1. Credit terms for sales are 2/10 net, 30 means that the amount is due in 30 days . However, if the
customer pays within 10 days, a 2% discount will be applied.
2. Average collection period = 10 days for 30% + 60days for 70% = 45 days
 Cost of Bank Finance = 500 x 2/3 x 22% x 45/360 = 9.17
Cost of own funds = 500 x 1/3 x 30% x 45/360 = 6.25
Total Cost of Funds on Receivables = 9.17+ 6.25 = 15.42
3. Discount/ Interest charge is calculated on the amount receivable after deducting factoring reserve
and commission.
Evaluation of In house Management
(i) Cash Discount = 500 x 2% (cash discount) x 30% (customers availing discount) = 3
(ii) Cost of funds in receivables (Note No. 2) = 15.42
(iii) Bad Debt Loss @ 2% = 500 x 2 % = 10
(iv) Lost Contribution on additional Sales = 50L x 20% margin = 10
(v) Administrative Overheads ​= 2.5
Total ​= 40.92
Evaluation of Recourse Factoring
(i) Factoring Cost (2% on total sales i.e. 500 + 50) 11
(ii) Discount Charge = (550 – 11) x 80% x 22% x 30/360 7.91
(iii) Cost of Long Term funds Invested in receivables (550 – 431.2) x 30% x 30/360 = 2.97
Total Cost 21.87
(iv) Benefits/ Saving Costs (3 + 15.42 + 10 + 2.50) 30.92
Net Benefit 9.05

Evaluation of Non Recourse Factoring

(i) Factoring Cost (4% on total sales i.e. 500 + 50) 22
(ii) Discount Charge = (550 – 22) x 85% x 21% x 30/360 7.85
(iii) Cost of Long Term funds Invested in receivables (550 – 448.8) x 30% x 30/360 = 2.53
Total Cost 32.38
(iv) Benefits/ Saving Costs (3 + 15.42 + 10 + 10+ 2.50) 40.92
Net Benefit 8.54

Decision: ​As a financial consultant, advice is to ​choose recourse financing ​due to higher net benefits.

4. A firm furnishes following information

Total credit Sales = Rs 75,00,000 pa
Average Credit Period = 60 days
Estimated Bad Debt Losses = 1% of credit sales
Current spending on credit administration = Rs 1,00,000 p.a.
The firm is planning to approach a factor in order to finance its credit sales. The factor charges 2% as
commission and makes an advance at the interest rate 17% retaining 10% as reserve. If the cost of
similar source of short term funds in the market is 18%, advice the firm whether to go for the
factoring option or not.

Solution:

(i) Factoring Commission = 75,00,000 x 2% = Rs 1,50,000

 (ii) Factor Reserve = 10% x 75,00,000 = Rs 7,50,000
(iii) Interest on advance = (75,00,000 – 7,50,000 – 1,50,000) x 17% x 60 ÷ 360 = 1,87,000
(iv) Cost of Factoring = 1,87,000 + 1,50,000 = 3,37,000
(v) Saving on Bad Debt Loss = 1% x 75,00,000 = Rs 75,000
(vi) Administration Spending Saved = 1,00,000
(vii) Total benefit = Rs 1,75,000
(viii) Net Cost of factoring = Rs 3.37 – 1.75 = Rs 1,62,000
(ix) Effective Rate of Interest of factoring = 1,62,000 ÷ 10,68,833 = 15.16%
Or 1,62, 000 ÷ 11,00,000, = 14.73%
Advance of each cycle = 75,00,000 x 90% x 60/360 = 11,25,000
Factoring Commission = 1,50,000 / 6 = 25,000
Interest = 1,87,000 / 6 = 31,167
Net Advance Received = 10,68,833
(x) Cost of Short term Fund = 18%
Hence, going for factoring is beneficial as the effective rate of interest in case of factoring is lower
than cost of short term capital in market

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