MODULE III

LEASING AND FACTORING

Leasing- Essentials – Types- Operating and Financial Lease -
Sale and Lease back- Other classi ications- Advantages and
Limitations of Leasing - Leasing Vs Hire purchase.
Factoring-Parties involved - Process of Factoring- Functions of
a Factor - Different Forms of Factoring Services- Factoring Vs.
Bill Discounting – Forfaiting - Mechanism of Forfaiting-
Factoring Vs. Forfaiting
(20 Hours)

CHAPTER 2

Factoring and Forfaiting

1. MEANING OF FACTORING
Factoring is a financial service that helps businesses to manage their receivables more
effectively. It involves outright selling a company's receivables to a financial institution known
as a ‘factor’, which specializes in trade credit management. The ‘factor’ manages the sales ledger
and collection process, allowing the organization to focus on their core business activities. The
‘factor’ is responsible for taking on the credit risks associated with account collection. For these
services, the factor charges a commission, usually a percentage of the value of the receivables.
It's called factorage. In certain situations, the factor gives an advance payment against the value
of the receivables.

2. DEFINITION
Factoring may be defined as the relationship, created by an agreement between the seller of
goods/services (client) and financial institution called the factor, where by the factor purchases
the receivables of the client and also controls and administers the receivables.

3. FUNCTIONS OF A FACTOR
1. Purchasing Accounts Receivables: A factor's primary role is to purchase debtor accounts
receivable (debtors) from a business at a discount. The factor deducts their fees from the
invoice value before paying the amount to the company.
2. Credit Recording: Factor maintains sales ledger, debtors ledger, collection schedule, discount
allowed etc..

1
3. Elimination of Credit Risk: The factor eliminates the risk of loss of the client by taking over
responsibility of book debts (accounts receivable) due to the client.
4. Advisory services: A factor advises the client on various matters, including, creditworthiness
of buyers, market trends, financial and fiscal policy etc…
5. Working capital management: Factoring services offer a remedy for clients facing working
capital constraints due to delayed payments from credit sales, by providing immediate cash
flow against their outstanding accounts receivable.

4. CHARGES OF FACTORING SERVICES

1. Factorage: The factor provides the various services at a charge. The charge for collection of debts and
sales ledger management is in the form of a commission as a percentage of the value of debt purchased.
It is collected in advance. It is called factorage.
2. Discount charge: The charge for short-term inancing in the form of advance part payment is in the
form of interest charge for the period of advance payment. It is called discount charge.

5. MODE OF OPERATION OF FACTORING

1) Factor and client enters into an agreement

2) Client sells goods to customers on credit sales basis
3) Client submits the invoices of selected customers to the factor for collection
4) Usually, factor provides inance to the client to the extent of 80% of the invoice value.
5) Factor periodically make follow up with the customer
6) Customer makes the payment to the factor
7) Factor pays the balance amount to the client after recovering necessary interest and other charges.
7. Pays the balance amount 6. Payment

Seller 1. Agreement 5. Follow up

Factor Customer
Company

4. Advance Finance

3. Invoices submission

2. Credit Sales

5. FEATURES/PROCESS OF FACTORING
1. Selection of accounts: In many cases, the factor purchases all the accounts of the irm. In such cases
the factor advices the irm to whom credit has to be given and the limit of the credit to each customer.
2. Collection of Accounts: The irm usually informs customers that the factor has purchased the loan and
instructs them to pay the factor immediately. If the business wants to keep the factoring agreement
private, it tells consumers to send their payments to a new address. At this address, factors get money
directly.
3. Recourse on Bad Debts: Normally, the factor has the right to demand payment from the business irm,
if one of its customers fails to pay.
4. Payments to the Firm: Usually, the factor pays the business irm based on the agreed collection period
or the account is collected, whichever is earlier.
5. Advances against Receivables: Sometimes, the factor may provide an advance against uncollected
accounts to the extent of 80 percent of their value to meet the irm's working capital requirements.

2
6. Factor Commission: The factor charges a commission for collecting and maintaining the sales ledger.
This is ixed as a lat percentage of the value of debts purchased.

6. TYPES OF FACTORING
A) Recourse Factoring: In recourse factoring, the factor buys a company's unpaid invoices and pays them
in a right way. But if a customer doesn't pay their invoice, the company has to buy back that unpaid
invoice from the factor. This protects the factor from not getting paid, but the company still in the risks
of not getting paid by customers.
B) Non-recourse factoring: In non-recourse factoring, the ‘factor’ assumes the credit risk of customer
non-payment. The company is not obligated to repurchase unpaid invoices from the factor. However, the
factor charges higher fees on factoring services to mitigate the increased risk they bear.
C) Advanced factoring: In Advanced factoring, the factor provides an advance payment, typically around
80% of the invoice value, and takes responsibility for collecting the full amount from the debtor. The
balance amount will be paid upon customer payment.
D) Maturity Factoring: Under maturity factoring services, no advance inancial assistance is made
available to the client and the client gets the entire amount from the factors only at the time of maturity.
The factor maintains the client's sales ledger and collects the debts on maturity and pays the same to a
client by deducting the commission thereon. A factor also renders advisory services to the client.
E) Bank Participation factoring: Bank participation factoring is a collaborative inancial service where a
bank joins with a factor to provide funding to the business. In this arrangement, the factoring company
is responsible for verifying the creditworthiness of customers, collecting payments, and managing the
day-to-day operations of the factoring process. The bank, on the other hand, provides the funds for
advance payment.
F) Undisclosed factoring: Undisclosed factoring, also known as con idential factoring, is a inancial
arrangement where businesses sell their accounts receivable to a factor without notifying the debtor.
The business receives an advance payment from the factor but retains control over the sales ledger and
customer relationships. The business instructs their customers to make remittances at a new address.
The factor makes the necessary arrangements to receive payments at this address. This method
maintains con identiality, allowing companies to secure immediate working capital while managing
customer interactions directly.
G) Disclosed factoring: Disclosed factoring is a inancial service where the seller’s customers are
informed that their invoices have been sold to a factor. The customers pay the factor directly, not the
seller. This transparency ensures that the customers are aware of the factor’s involvement. It is also
called ‘Bulk factoring’ or ‘Noti ied factoring’.
H) Domestic Factoring: In domestic factoring, all the parties involved in the factoring, viz. Seller. Buyer,
and the factor are reside in the same country.
I) International Factoring/Export factoring: International Factoring involves the sale of accounts
receivable arising from export transactions to a factoring company. It helps exporters manage credit
risks, improve cash low, and facilitate international trade by providing inancing and credit protection
services across borders.
J) Supplier Guarantee Factoring: This type of factoring arrangement is designed to help a irm which acts
as an intermediary (distributor or wholesaler) between the supplier and the customer. This type of
factoring arrangement is designed to help a irm which acts as an intermediary (distributor or
wholesaler) between the supplier and the customer
K) Agency Factoring: In this type of factoring the factor and the client share the works between
themselves. like, the client would look after sales ledger administration & collection work and factor
would provide inance & assume credit risk.

3
L) Limited Factoring: When the factor does not take all the invoices of the client, it is known as limited
factoring. the factor discounts only selected invoices on merit basis.
M) Full Factoring: Under this method, the factor performs all the services of factoring including
inancing, collections, sales ledger administration and credit protection. It is also known as conventional
factoring.
N) Selected buyer based factoring: Under this, the factor maintains a list of 'approved buyers' and any
claims on such buyers (by any seller) would be factored.

7. MERITS
1) Better Cash Flow: Factoring is a great source of cash in low especially for industries where receivables
take a long time to convert to cash.
2) Liquid cash: Young businesses have high overheads and daily operational costs. Factoring provides
liquid cash in the short-term with minimal risk.
3) Expert knowledge for decision: The irm enjoys bene it from the expertise of the factor in its credit
decisions.
4) Better debt collection: A irm which has a large number of debtors to be monitored and where the
risk of default is rather high (like a fertilizer unit) bene its by factoring its receivables.
5) Better ef iciency: The client (selling irm) can concentrate on other major areas of the business and
improve the ef iciency. The factor provides specialised services with regard to sales ledger
administration, credit control etc. and relieves the client from the botheration of debt collection.
6) Better credit rating: Reduction in bad debts and administrative expenses will improve the current
ratio of the client and consequently his credit rating.

8. DEMERITS
1) Costly: Factoring can be a costlier alternative to in-house management of receivables. Especially large
irms have streamlined their receivables management and have access to cheaper sources of short-
term credit.

2) Distrust by creditors: The creditors of a irm generally consider factoring as a sign of deterioration in
the inancial health of the irm. The creditors look upon receivables as a source of future in low which
will enable the irm to meet their maturing claims. Therefore, when a irm factors its receivables, the
creditors may perceive that the irm must be experiencing inancial dif iculties forcing it to borrow now
at a higher cost against its future in lows.

3) Over con idence: It may lead to over-con idence in the behaviour of the client resulting in overtrading
or mismanagement.

4) Risky: The possible fraudulent acts by client like pre- invoicing, duplicate invoicing, invoicing against
non-existent goods etc. increases the risk element of factoring.

5) Uncertainty: Rights of the factor resulting from purchase of trade debts are uncertain, not as strong
as that in bills of exchange and are subject to settlement of discounts, returns and allowance.

6) Unsuitable for small companies: Small companies with lesser turnover companies having high
concentration on a few debtors, companies having large number of debtors for small amounts etc. may
not be suitable for entering into factoring contracts.

4
9. FACTORING IN INDIA
 The Reserve Bank of India constituted a group in January, 1988 under the
effective chairmanship of Mr. C.S Kalyana Sundaram, former director of
State Bank of India, to investigate the feasibility, viability and mechanics of
commencing a factoring organization in India.
 Based on the recommendations of the committee, the Reserve Bank of India
issued guidelines and amended Banking Regulation Act in 1991, permitting
commercial banks to start separate subsidiaries for rendering factoring
services.
 In, India, the irst company engaged in factoring commenced on 18th April
in the year 1991. The irst institution of factoring was established as SBI
factors and Commercial Services Ltd. promoted by State Bank of India, State
Bank of Saurashtra, Union Bank of India, Small Industries Development
Bank of India (SIDBI) and State Bank of Indore.
 The other factoring companies engaged in factoring and made a mark in the
industry were Canbank Factors Ltd. and India Factoring and Finance
Solutions.
 The new entrants in the market include ICICI, HSBC, Global Trade Finance
etc.
 The major players since 1991 are CANBANK Factors Ltd. and SBI Factor.
CANBANK Factors leads in the domestic market with about 65%-70%of the
share.
 The types of factoring available in India are three;
I. On the basis of Credit risk
a. Recourse Factoring
b. Non-Recourse Factoring
II. On the basis of location
a. Domestic Factoring
b. International Factoring
III. On the basis of Information
a. Disclosed Factoring
b. Undisclosed Factoring

5
10. FACTORING VS BILL DISCOUNTING
BILL DISCOUNTING FACTORING
1. Loan/Finance alone is provided 1. Both inance and integrated receivables
management are provided

2. Advance is made against bills of exchange 2. Advance is made against trade debt

3. It is always with recourse 3. It is with or without recourse

4. Charge is registered against drawee 4. Charge is against owner of trade debt.

5. Individual transaction oriented 5.Whole takeover and bulk inance is

provided

6. Drawee has to accept the bill 6. Noti ication is suf icient for transfer of
receivables and all future transactions

11. MEANING OF FORFAITING

Forfaiting is a form of inancing of receivables pertaining to international trade. Forfaiting is a
technique to help the exporter to sell his goods on credit and yet receive the cash well before
the due date.

Forfaiting is de ined as the non-recourse purchase by a bank or other inancial institution

(Forfaitor) of receivables arising from an export of goods and services. The exporters get the
money soon on receipt of the bills from the importer which is presented to the forfaitor.

12. MODE OF OPERATION OF FORFAITING

1. The importer places an order for purchase of goods with the exporter.
2. The exporter will ask the forfaiting bank, through a forfaitor for providing forfaiting services
referring to the order from importer.
3. After checking the credit worthiness and relevant details of importer, Forfaiting bank accepts
to provide service.
4. Gaining guarantee from forfeiting bank, the exporter sells the goods to the importer
5. Exporter receives the bills of exchange from the importer.
6. The exporter submits the bill to the forfaitor and collects money from forfeiting bank against
the bill.
7. On maturity date of bill the Forfeiting bank collects the money from the importer's bank with
which the importer gained guarantee.

6
 5. Bills of exchange

Exporter 4. Sale of goods importer

1. Purchase order

2. Agreement 7. Payment 8. Final payment

6. Bills of exchange –
submission for payment

Forfaitor 3. Accepts the process Forfai ng Bank

FACTORING FORFAITING

Factoring is the inancing of domestic Forfaiting is the inancing of scheme, export

invoices/book debts at a discount. receivables/foreign credit bill with respect to
foreign trade.

A factor inances usually 75-80% of the value of A forfaitor inances 100% of the export bills.
account receivables/invoice.

Factoring may be with or without recourse. Forfaiting is always without recourse.

No bank guarantee or letter of credit required for Letter of credit or bank guarantee is required for
factoring arrangement. forfaiting each export receivables.

Factoring arrangements can be used for both Forfaiting is only for export receivables
domestic and export receivables (international inancing.
factoring).

No restriction on minimum size of transactions. The minimum value of transaction is USD

100,000