Documents under Documentary Credits-Part VI

In this concluding article on documents that are dealt with under documentary credits, we shall examine insurance and other documents that are required to fulfill certain official requirements, like the Certificate of Origin.

Insurance Documents:  Insurance documents are also called risk covering documents, because they are concerned with providing cover to eliminate or mitigate the risk associated with the international trade transactions, where merchandise is transported from one country to another.  This is fraught with consequences both for the exporter and the importer, apart from the Bankers who have a valuable interest in these transactions.   Practically, no international trade transaction takes place nowadays, without the support of insurance cover to take care of the inherent risks of international trade.

The most common type of insurance policy prevalent in international trade is the Marine Insurance Policy, because the major portion of the international trade is carried over the seas and oceans.   Within this category of insurance, there are different policies to suit the nature of merchandise and the nature and quantum of risk associated with the voyage, etc.  For instance, perishable goods being exported over long distances would require additional facilities to ensure their safe and sound arrival at the port of delivery, and requires a different kind of insurance policy compared to the export of iron ore, for example, from one part of the world to the other.   Similarly,  the menace of the Somalian pirates in the Gulf of Aden would require a suitable coverage for merchandise passing through the Gulf of Aden.  

Insurance policies to cover international trade transactions may be of two types-specific or open.   The specific policy is one that covers a particular voyage involving the  specific merchandise.   The insurance cover will cease upon the completion of the voyage.   On the other hand, the open policy is one where the insurers issue a blank policy to cover shipments of different types of merchandise to different consignees, and deliverable at different ports.   The shipper is permitted to effect any number of shipments to any number of destinations within the overall limit fixed for him by the insurer.   Generally, the only requirement is for the shipper to give prior notice of each shipment within the specified time limit and become eligible for the cover.

Another important feature of insurance policies is that they are freely assignable by blank endorsement, without notice to the insurers.   Any person acquiring an insurable interest in the policy gets the necessary cover from the insurer.

Insurance Cover Note:  Sometimes, the details of the shipment or the ship are not available, and it become difficult to obtain a specific insurance policy for the goods.   As a stop gap arrangement, till such details become known, the insurance company issues a Insurance Cover Note, valid for a short period of time, that would enable the shipper to provide the full details of the shipment and the ship or vessel.

Certificate of Origin:  Certain countries require of the importer to obtain from the exporter, a certificate testifying to the fact of the local origin of the merchandise that is being imported.

The purpose of this document is to ensure that goods are exported from the country that is not in the blacklist of the importing country.   Apart from that, it also serves the purpose of complying with official requirements in regard to quotas, if any, applicable to the exporting country, under different international trade agreements.

Summary:  To summarise, there are different types of documents required to be submitted by the exporters and importers under the mechanism of the documentary credit.   Broadly, these documents may be divided into Financial documents, Commercial documents, Transport documents, Insurance documents etc.

Among the financial documents, the Draft or the Bill of Exchange is the primary one, that facilitates payments for the exports made by the seller.  

Among the commercial documents, the invoice is the King, that provides all the details of the transaction, with reference to the merchandise, the quality, the quantity, the rates, the discounts offered, the net price, the ports of loading and delivery, the payment terms etc.  

Among the transport documents, of course, the Bill of Lading is the Queen.   Being a quasi negotiable document, it is a document to the title of goods, and enables the consignee to take delviery of the goods that he had ordered from the exporter.  

And finally, among the risk covering documents, the Insurance policy holds the pride of place. 

                                                                                                           Concluded

Documents under Documentary Credits-Part V

In previous articles we had studied some of the types of Bills of Lading.   In this article, we shall study the remaining types of this important transport document, as well as the Airway Bill and other such documents that are utilized when shipment is made by air.

1)  Container Bill of Lading:  This bill of lading indicates that the goods under shipment are packed and are carried in containers, and not spread out as loose cargo.   This means the goods are secure and at one place which makes it handy to deal with.

2)  Combined Transport Bill of Lading:  This bill of lading is issued when the goods under shipment have to cover the voyage utilizing different modes of transport, like in the case of the through bill of lading.   However, the difference here is, that the carriers or their agents take responsibility for the sound condition of the goods, and its safe delivery at the port of destination.

3)  Lash Bill of Lading:  Sometimes goods are loaded on a barge to be unloaded on to a parent vessel.   In such cases, the bill of lading issued is called the lash bill of lading.   This bill of lading is similar to the ‘received for shipment’ bill of lading.   However, such a bill of lading can be upgraded to a regular ‘on board bill of lading’ with the help of a clause to that effect.   The clause states that the goods on the barge are put on board the parent vessel.

Apart from the above types of bills of lading, there are a few others like the “Crocka Bill of Lading”, issued by carriers to cover the journey of goods by road;  and “House Bill of Lading” issued by associations of forwarding agencies that do now own vessels.

Airway Bill:  Where goods are exported or transported by air, the concerned Airline company issues an Airway Bill, just like the sea carriers issue a Bill of Lading.   However, airway bills are not negotiable instruments, and hence not compulsory to be in possession of the consignee to enable him to take delivery of the consignment.   Hence it is not all that safe.

The Airway bill is an acknowledgement  of receipt of goods within mentioned by the Airline company or their authorised agents, for the purpose of despatch by air to the named consignee.   Normally the goods are kept at the designated delivery point of the Airline company and the consignee is expected to take delivery of the same.   The Airline company delivers the goods to the consignee after proper identification.

Air Consignment Note:  This is issued by the forwarding agents of the Airline companies.   It contains details of the merchandise, the name and address of the shipper and the consignee.

House Airway Bill:  There are what are called as Consolidating Agents, who consolidate air cargo on behalf of a number of consignors or shippers, and book the same for despatch by an Airline company.   The Airline company, in turn, issues only one Airway Bill to the consolidating agent.   The agent then issues a House Airway Bill to each of the shippers.

Postal Receipt:  Another way of despatching merchandise in international trade is through the medium of the Postal Authorities.   This despatch may cover sea voyage, or air travel, or both.

Multimodal Transport Document:  Also called Combined Transport Document, it involves different modes of transport through which the goods have to pass, before reaching the port of destination.   This one document takes care of the entire voyage or journey of the consignment, without the seller having to arrange for multiple transport documents.

                                                                                      To be concluded

Documents under Documentary Credits-Part IV

In the previous article, we had studied what is a Bill of Lading, and the purpose it serves, and how it facilitates the trade between exporters and importers in different countries.   In this article, we take a look at the different types of Bills of Lading.

1.  On Board Bill of Lading:  This is the preferred type of bill of lading and universally acceptable.   In fact, as a general rule, this type of bill of lading is insisted upon, on account of its soundness in relation to the underlying terms of carriage and the protection it offers to both the buyer and the seller, apart from the Bankers who are party to the transaction.

This bill of lading acknowledges the fact that  the goods under the contract have been put on board the named vessel, for shipment to the named port.   For the exporter, this document fulfills his legal obligations as to acceptable form of delivery under the contract.   Being universally acceptable and legally sound, the On Board Bill of Lading offers the exporter, the assurance of proper completion of shipping formalities.   For the importer, the On Boarad Bill of Lading evidences the shipment of the contracted goods on board the named ship, and deliverable at the named port.   As all the details are specific, including the name of the vessel, the importer enjoys peace of mind, not having to worry about the location of the merchandise or the carriage conditions applicable to it.

The On Board Bill of Lading invariably bears a notation “Shipped on Board” or similar term, testifying to the fact of the goods being loaded on board.   As pointed earlier, this is the preferred type of Bill of Lading.

2)  Received for Shipment Bill of Lading:  This Bill of Lading merely acknowledges receipt of goods for shipment.   It does not specifically state by which ship or vessel the goods would be transported, and when.   In case of delay in transporting,  goods may be stored in the warehouse till such time as they are actually transported by the next available ship.

This type of Bill of Lading is inferior to the On Board Bill of Lading, and generally not preferred.

3)  Short Form and Long Form Bill of Lading:  In the Short Form Bill of Lading, the terms and conditions for carriage of goods are not mentioned as is the normal rule.   Instead, this bill of lading  provides details of the consigner, consignee, the name of the vessel, the date of shipment, the port of loading and delivery, etc.   Charter Party Bill of Lading is generally of this type.

The Long Form Bill of Lading is just the opposite of the Short Form one.

4)  Clean Bill of Lading:  A Clean Bill of Lading indicates the absence of onerous notations and clauses relating to the defective condition of the goods.   A Clean Bill of Lading means the carrier has received the goods in order, that is, they are apparently in sound condition.   This is a major plus point,  both for the exporter and the importer.   The carrier is acknowledging the fact that the goods are received in good order, and consequently, he is obliged to deliver them in the same condition and order.

5)  Claused Bill of Lading:  This is the opposite of the clean bill of lading.   This bill of lading contains clauses and notations referring to the defective condition of the goods under shipment.   This is not good for the exporter, as well as the importer. 

In a case like this, the carriers and their agents are not responsible for delivery of the goods in good condition, as they have not received them in such good condition, in the first place.   This is also called a “Dirty Bill of Lading”.

6)  Through Bill of Lading:  It is a bill of lading that is issued to cover the entire voyage by utilizing more than one mode of transport.   Since the goods have to be transhipped, the carriers involved do not give an undertaking to ensure safe delivery of goods.

7)  Straight Bill of Lading:  A  Bill of Lading in which the goods are to be delivered directly to the consignee, bypassing the usual procedure is called the straight bill of lading.   It is risky to deal in such bills of lading.

8)  Charter Party Bill of Lading:  Where a vessel is hired or space within the vessel is hired to effect the shipment of goods by anyone, the bill of lading covering such shipments is called the Charter Party bill of lading.

                                                                                                  To be continued.

Documents under Documentary Credits-Part III

In earlier articles, we had studied about financial and commercial documents that are dealt with under Documentary Credits(DC).   In this article, we shall study the Transport Documents involved in international trade transactions, that are part of the documents dealt with under DC.

Transport Documents:  In trade transactions, whether domestic, or international, movement of goods or merchandise is one of the most important and critical functions.   Especially in international trade involving movement of merchandise from one country to another, with different rules, regulations, customs, etc., it is of prime importance to ensure safety, security and proper despatch and receipt of the goods, from end to end, without any mishap in between.

There are different ways of transporting merchandise like by way of land, water and air.   The major portion of international trade  is effected by water involving ships and other vessels of various descriptions.   And the transport document involved in transporting goods by sea or ocean is called the Bill of Lading.

Bill of Lading:  This document is issued by the shipping company or carrier, that owns the ship through which the merchandise is exported.   Alternatively, it may be issued by the agents of the shipping company.  

The Bill of Lading is an acknowledgement by the shipowners or the carriers, or their authorised agents, of having received the merchandise to be shipped, from one place to another, as specified, and to be delivered to the person named in the Bill of Lading as the consignee.

The shipowners or carriers require of the seller or exporter or the shipper of goods to declare the nature of goods, the quantity, the quality, description, weight, etc., of the goods to be shipped.   They, in turn, acknowledge receipt of such merchandise, and loading the same on to a named vessel.   They further undertake to deliver the merchandise at the specified port of destination, and to the named person, or consignee, subject to certain terms and conditions.   The Bill of Lading is thus, a contract of carriage of goods.

The Bill of Lading is also a document of title to goods, as the merchandise is deliverable to the consignee named in the transport document.   In other words, the consignee has the right to receive the merchandise on the strength of the Bill of Lading.   The Bill of Lading testifies to the entitlement of the consignee to receive the goods shipped therein.

From the above it is seen that a Bill of Lading is a vital document that conveys the passage of the  merchandise from the exporter’s country to the importer’s.   Further, it testifies to the conveyance of the title of goods from the exporter or seller to the importer or buyer.

The Bill of Lading evidences three stages of the transaction, beginning with the loading of the merchandise on the vessel named for the purpose;  secondly, the voyage undertaken by the vessel from the port of loading to the port of delivery, and berthing at any port in between;  an thirdly, delivery of the merchandise at the destination port to the consignee, who is entitled to receive the goods.

The Bill of Lading is a unique document, in that, it combines the qualities of a full fledged transport document with certain qualities of a financial document, like a Bill of Exchange or Draft.   As we have seen,the Bill of Lading entitles the consignee to receive the goods by endorsement and delivery of the document, thereby putting the goods into his possession.   However, a Bill of Lading, being essentially a carriage contract, is subject to laws relating to the carriage of goods, and not to the negotiable instruments like the Draft.   Hence, the Bill of Lading is also called a Quasi Negotiable Instrument.

The Bill of Lading vies with the Bill of Exchange in importance and effect.   While the Bill of Exchange deals with the payment aspect for the merchandise being traded, the Bill of Lading deals with the delivery aspects of such merchandise.

There are different types of Bills of Lading, that will be discussed in future articles.

                                                                                           To be continued.

Documents under Documentary Credits-Part II

In the previous article, we had studied the Draft or Bill of Exchange in the context of Documentary Credits(DC).   In this article, we shall study the Commercial documents that are dealt with, under the DC.

Commercial Documents:  In any trade transaction, be it domestic, or international, certain documents are necessary to put the transaction through.   One such category of documents is the commercial documents,  of which some of the important ones are discussed below.

Commercial Invoice:  The invoice is a basic document that describes the merchandise involved in the transaction, and gives all other related information.

Normally, the invoice contains the description of the goods, apart from the quantity, quality, the unit price, the total cost, the duties, taxes, if any, any discounts allowed, the net price, etc.   It also contains a reference to the Documentary Credit, under which it is drawn, with the relative order number etc.   It also mentions the destination of the goods, the port of delivery, the shipping marks on the packages etc.

The commercial invoice serves the purpose of conveying the details of merchandise being traded, and enables cross checking of the same, at the buyer’s end, to facilitate the closure of the transaction to the satisfaction of both the buyer and the seller.

Sometimes, the commercial invoice is preceded by what is known as the Proforma Invoice.   The Proforma Invoice is similar to the regualar Invoice, and enables the buyer to know the details of the goods to be supplied, and enables him to take a view of the same and also seek clarifications as required.

Packing List:  This document gives the details of the packages in which the merchandise is packed and shipped.   It also  gives details of goods packed in each package or container, as to its nature, quantity, size, distinctive markings,  etc.

The purpose of this document is to enable the buyer or the importer,  to know at a glance, what has been shipped, and to compare and satisfy himself about the correctness of the contents in relation to the Documentary Credit.   This also facilitates the onward shipment of goods where the ultimate buyer may be  different.   Further, the packing list enables the Customs authorities in the importer’s country to complete their formalities, without problems.

Weight Certificate:  As the name indicates, this document gives the weight of the merchandise according to its classification and division, i.e. either into individual units or groups of units.

Quality Certificate:  The exporter may be required to send a certificate of quality alongwith the other documents to the importer.   This certificate testifies to the fact that the shipped goods are in comformity with the quality as required under the Documentary Credit.   Sometimes, the importer may require independent  certification of quality for the goods. 

Inspection Certificate:  Often the importer, for his own satisfaction, or in order to comply with his country’s requirements, demands a Inspection Certificate from the exporter, for the goods supplied.   This inspection is done before the goods are shipped.

Health Certificate:  This certification is necessary when the object of the trade are live animals and birds.   Invariably, both the exporting and the importing countries  require a health certificate, testifying to the fact that the animals and the birds being traded are healthy and are free of any diseases.

                                                                                     To be concluded

Documents under Documentary Credits-Part I

Introduction:  A Documentary Credit is a financing mechanism widely used in both domestic, as well as international trade.   It is an undertaking of a Bank, on behalf of its customer, to make payment against submission of specified documents by the seller of goods and services.

Documents under Documentary Credits:  There are four types of documents that are dealt with under a Documentary Credit.   They are Financial Documents, Commercial Documents, Transport Documents and Insurance Documents.   Apart from these four, there is another set of documents called the regulatory documents.

 Financial Documents: 

Draft or Bill of Exchange:  This is the most important of the financial documents.   A Draft or a Bill of Exchange may be defined as a financial instrument drawn by one person called the Drawer upon another called the Drawee, demanding payment for the goods or services supplied, in terms of the relative Documentary Credit.

In the specific context of international trade, a Bill of Exchange is drawn by the exporter on the importer making a demand for payment of a specific sum of money for the supply of goods and or services as specified under the relative Documentary Credit.   The Bill of Exchange must also be drawn as required under the Documentary Credit.

The Draft or Bill of Exchange testifies to the fact that there is a commercial transaction underlying this instrument involving the sale and purchase of goods and services.   These goods/services are defined under the Documentary Credit.   There is a specific value of these goods/services.   And they have to be supplied within a specified period.   That makes it incumbent upon the drawee to make payment for the goods/services received under the Documentary Credit, within the specified time.   This specified time for the payment may be immediate, i.e. at sight, which means the drawee has to make good the payment on presentation of the documents, or on demand, or at sight.  

Or the documents may be drawn on usance basis, where the drawee is given time to make payment after a certain number of days, from the date of the Draft.   This method of payment is again divided into two types.   The first being on DP basis,  i.e. documents against payment basis.   Here documents are released to the drawee only upon payment of the Draft.   The second type being DA basis, i.e. documents against acceptance basis.   Here documents are released to the drawee upon acceptance of the Draft by him and to be paid on maturity date, as per the terms of the Documentary Credit.

The Bill of Exchange has legal status, except in certain countries, where it is stated otherwise.   It is an all important documentin a Documentary Credit, that enables the beneficiary of the Credit to demand and receive payment.   It also acts as a receipt for the drawee when acknowledged as such by the drawer.   Hence it is a comprehensive financial instrument that facilitates the international trade transactions by offering the means for compliance of the terms of the Documentary Credit.   It is a medium that brings together the exporter and the importer, and binds them together under a financial pact, that protects the financial interests of both of them.

Looking to the importance of this document, it is imperative that it be drawn properly and worded as per internationally acceptable standards to avoid any misinterpretation, or misunderstanding or even misuse.   It must be specific and unambiguous.

Other Financial Documents:  Among the other financial documents that are noteworty is the Promisory Note.   A Promisory Note is also a financial instrument, in writing, drawn by a person called the Maker, who promises to pay a specific sum of money to the person called the Payee.   The Promisory Note may be payable on demand, called a Demand Promisory Note, or payable after a certain period of time from the date it is drawn, called Usance Promisory Note.   In the context of international trade transaction, the Maker of the Promisory Note is the buyer or the importer, and the Payee of the Promisory Note is the seller or the exporter.

                                                                                           To be concluded

 

Finance: Forfaiting-Part III

In earlier articles, we had discussed what is forfaiting and how it works.   In this concluding article, we shall examine the benefits of this system of international trade finance.

The benefits or advantages of Forfaiting may be studied in relation to the parties to the transaction.

Benefits to the Exporter(Seller): 

1)  Elimination of Risk:  One of the major advantages or benefits of Forfaiting is the elimination of risks, to a large extent, mainly of a political, financial, and commercial nature.

Political risk may arise on account of factors like War, Civil War, Disturbances, lack of foreign exhange reserves, restrictions on foreign trade, etc.  

Transfer or payments risk  may arise on account of currency conversion issues.  

 Commercial risk may arise on account of the insolvency or bankruptcy of the importer or even the importer’s Bank, or disputes relating to the merchandise, etc.   Another risk is that of interest rate changes and currency rate fluctuations.

2)  Improves Cash Flows:  One of the major parameters for judging the health of a company is the soundness of its cash flows.   Especially for small and growing concerns, timely conversion of their inventories and recievables ensures a steady supply of internal finance for the purpose of faster turnover and higher sales.

Forfaiting helps an exporter convert his credit sales into cash immediately.   That too, to the full extent of the bill amount.   This type of financing provides much needed maneuverability to the exporter in relation to his future plans, and to be aggressive in the pursuit of his business goals.

3)  Gives Competitive Edge:  In a highly competitive environment, buyers are always looking for value for money, and a good deal.

Often, exporters are under pressure to afford credit to their foreign buyers.   Forfaiting comes to the aid of the exporters by encashing their export documents for the full value, while allowing the exporters to export their merchandise on credit.   This adds to the competitive edge of the exporter.

4)  Opens New Markets:  Often, exporters are constrained in their efforts on account of the uncertainty of payments for exports made.   Forfaiting relieves the exporter of this burden, as forfaiting transactions are always without recourse to the seller(exporter).   That is, the forfaiter cannot demand repayment from the exporter in the event of the importer’s default.

5)  Administrative and Legal Issues:  Forfaiting relieves the exporter of the time consuming and sometimes onerous responsibility of administrative and legal work in connection with realization of export proceeds.   The ‘headaches’ associated with export transactions are transferred to the forfaiter.

Benefits to the Forfaiter:

1)  Eliminates Payment Risk:  In business, especially so in international trade, risk comes in many forms, and often small and minor mistakes can prove costly and result in loss either in monetary terms or in terms of prestige, reputation, etc.   And one of the most serious such risks is the risk of non-payment.

In forfaiting, the forfaiter is practically assured of payment, as the exporter’s Draft is pre-accepted by the importer, and further avalized by the importer’s Bank.   Even though payment defaults may still arise on account of insolvency, etc., the degree of safety enjoyed by the forfaiter does make life easier for him.

2)  Remunerative:  The forfaiter is entitled to various pecuniary benefits in forfaiting.   For example, a forfaiter charges interest for the period of credit he extends to the exporter.   Secondly, the forfaiter charges a fee for the various risks associated with the transaction.   Thirdly, the forfaiter charges a certain amount for expected delays in getting reimbursement from the importer.  This is specific to the country of the importer.

Benefits to the Importer(Buyer): 

1) Documentation:   The major advantage to the importer is the assurance that the documents from the exporter have been screened by a professional agency, thereby reducing the risk of misinterpretation, communication gaps, etc.

2) Credit Facility:  Another benefit for the importer is that, he is able to get the goods on credit which provides him space to arrange for payment from the proceeds of the consignment that he has imported, rather than pay upfront.

                                                                                                Concluded

Finance: Forfaiting-Part I

Introduction:  Financing of international trade is a complex and sophisticated affair.   It requires a mechanism that addresses the concerns of both the exporter(seller) and importer(buyer).   Obviously, there are several issues, some of them ticklish in any cross border trade transaction.

Some of the major issues involved here have to do with the solvency and standing of the buyer and seller, the local laws in the respective countries, the different currencies and their differing values, the customs and practices in the two countries impacting on the trade transaction, even the different languages spoken in the two countries, etc.

Such a tall order of demands on the exporter and importer calls for a system that is comprehensive in its scope and application.   Some of the popular systems under which international trade transactions are undertaken are Documentary Credits, and Letters of Guarantee.   Another system or mechanism to conduct foreign trade transactions that is being increasingly used is called “Forfaiting”.

What is Forfaiting?   Forfaiting is a mechanism to finance international trade under which the exporter(seller) gets his Drafts or Bills of Exchange pre-accepted by the importer(buyer) and further avalized by the importer’s Bank, and gets the same purchased by the Forfaiter.   The term “Aval” means a sort of guarantee or commitment on part of the importer’s Bank to honor the exporter’s pre-accepted Draft, irrespective of the importer’s conduct in this regard.

After parting with money to the exporter against the pre-accepted Draft, the Forfaiter, in turn, collects the proceeds of the same from the importer.   Further, this transaction is without recourse to the seller.   That is, the forfaiter cannot revert to the exporter in the event of the importer’s default.

The forfaiter may, in the normal course, wait for his payment to come through the importer’s Bank.   Or, he has also the option to sell the Draft or Bill of Exchange, that he has purchased, to another forfaiter, for consideration, also without recourse.   Thereafter the second forfaiter will claim the proceeds of the Draft from the importer.

The forfaiter is the financier who advances money to the exporter against pre-accepted Drafts and claims his dues from the importer.   And he undertakes this risk without recourse.   That is, if the importer does not pay, the forfaiter accepts the loss.   The most popular instrument against which the forfaiter extends financing is the Draft or Bill of Exchange.   A Bill of Exchange is a financial document that is drawn by the seller on the buyer demanding payment for the goods or services supplied.   It mentions the amount, date, buyer’s name, etc., on the face of it.

There are three major features of a forfaiting transaction.   One, the forfaiter purchases the exporter’s Draft for the full value of it(100%).   Unlike in a factoring transaction, where a part of the bill amount is retained by the factor as a reserve.

The second major feature is that the forfaiter undertakes  this transaction without recourse to the seller.   The forfaiter cannot revert to the seller to recover the money he had advanced to the seller, in the event of default in payment by the buyer.

The third major feature of the forfaiting transaction is that the forfaiter is practically assured of payment, because the Draft is pre-accepted by the buyer, and also avalized by the buyer’s Banker.

Apart from the above, there are other features and points of interest and value in forfaiting transactions, like there are minimum and maximum limits for the Drafts to be drawn.   Further the Drafts are drawn in the world’s major currencies.

                                                                                            To be continued.

Finance: Factoring-Part IV

In previous articles, we have studied what is factoring, and the prospects and advantages of the business.   In this concluding article, we shall study the risks and disadvantages of  this business to the parties involved.

Risks and Disadvantages:

1) Credit Risk:  This is one of the most serious risks faced by the Factor.   The Factor depends upon the financial integrity and standing of the Buyer or Debtor, for repayment of his debt, originally extended to the Seller.  The solvency, or otherwise, of the Buyer is a critical factor in the health of the Factor’s credit portfolio, especially so, in the without recourse factoring transaction.   The Factor has to conduct proper and comprehensive due diligince of the Buyer before committing to the Seller.

Another risk faced by the Factor is the absence of any collateral, either from the Seller or the Buyer, except for the reserve money, that is not sufficient to offset the default of the Buyer.   Further the percentage of such reserve money goes down in proportion to the creditworthiness of the Buyer.    Lack of such a safety net exposes the Factor to predatory market forces.

For the Seller, any default on part of the Buyer is bad news.   Because part of the blame for the Buyer’s default would be attributed to the Seller, by the Factor, who may have a different perception of the entire issue.   And if the instances of such default increase, then the Seller may not be in a position to get any Factor to advance money to him against his invoices.

For the Debtor, the risk in this transaction is that, there is no guarantee of the facility of rescheduling debts as normally available for Bank loans.   The Factor may not be in a position to offer the same kind of credit regimen as offered by a Bank, for various reasons.

2)  Risk of Negligence and Fraud:  Factors also face the risk of negligence and fraud on part of either the Seller or Buyer, or sometimes both of them in collusion.

Sometimes the Seller may be negligent in drawing up the commercial documents as required under the contract.   This could give the Buyer an opportunity to renege on his committments under the transaction, or to delay compliance of his contractual obligations.   This would naturally put the Factor to financial and other risks.

Sometimes, there is also the possibility of the Seller and the Buyer committing frauds on the Factor, either individually, or even together.   One such common practice is to draw up fake invoices, that do not represent genuine business transactions.   In such a case, the Factor would, in good faith, advance money to the Seller, and demand payment from the Buyer, without realizing that he could be exposing himself to costly litigation, apart from having lost the money advanced to the Seller.  

And where such frauds are commissioned jointly by the Seller and the Buyer, the Factor could be practically running from pillar to post, with the Seller and Buyer having a good laugh over it!

For the Seller and the Buyer, the risk of negligence or fraud, committed by either of them, could mean avoidable expenses and inconvinience.   Apart from the loss of reputation in the market.

3)  Compliance Risks:  Every business is subject to certain rules and regulations.   And different countries have different regulations for the same kind of business.   That apart, local customs, practices, and usages play their own part in either easing or further complicating the business transactions.

Especially for smaller companies, without the benefit of deep pockets, or access to competent legal and administrative talent, complying with myriad regulations can be debilitatingly expensive, apart from being traumatic.   This could affect their bottomline adversely.

All the three parties to the factoring transactions, namely the Seller, the Factor, and the Debtor face their individual share of problems, and also certain common problems.

It is pertinent to note that there are ways of mitigating the risks discussed above, like obtaining a suitable insurance policy by the Factor, for example.   But that would increase the transaction costs overall.   And non compliance of the rules and regulations by any one of the parties can expose the others to risks and losses.

On balance, it may be said that Factoring, in spite of its limitations, has a crucial role to play in furthering business, by providing finance to businesses, especially those that find it hard to access Bank funds.

                                                                                         Concluded.

Finance: Factoring-Part III

In the earlier articles, we had studied what is factoring, and how it works, with the help of a simple example.   In this article, we shall study the advantages of the Factoring business to the parties concerned-the Factor, the Seller, and the Debtor.

Advantages and Prospects:

 1)  Cash Flows:  Factoring is necessarily related to the cash flows of a business.   Every business has to maintain a certain level of cash for its day to day operations, as well as emergent needs.   This can be tricky.   A higher or a lower level than required, of cash holding can be harmful for the health of the business.

Cash flows vary from Company to Company, depending upon their product or service, and the customs and practices of the market they operate in, apart from other things.   Generally speaking, the faster the realization of credit sales of a Company, or more the percentage of cash sales over the credit sales, the better the cash flow of the Company.   As proceeds of past credit sales go into the production cycle, new products and services are generated, enabling the Company to grow at a steady pace.   Further, the burden of interest is also reduced.

For the Factor, the advantage is in the solvency of the Buyer, that ensures a steady income for it.   Even if the Seller is not creditworthy for the comfort of the Factor, it does not matter, as the Factor is assured of payment from the Buyer.

For the Buyer, the advantage is that, he enjoys a credit of certain number of days, on account of the involvement of  the Factor, who has the capacity to advance money to the Seller and wait for the Buyer to make good the payment.

2)  Boost in Business:  Factoring is helpful to the Seller in encashing a decent part of its credit sales immediately through the agency of the Factor.   This enables the Seller company to deploy these funds into the next production cycle.   That means a higher turnover, and presumably,  higher sales.  

 It also enables the Seller to respond to demand for their products and services from new markets, with speed and efficiency, thereby increasing their overall market share.   So, factoring not only helps the seller in consolidating his present market, but also exploring, and getting a toehold in new ones.

For the Factor and the Buyer, more busines from the Seller means more business, and more profits for themselves.   It is a mutually beneficial arrangement.

3) Easier Access: Any business needs money to run.   And business in the modern environment is not conducted with one’s own money, but with others’!   The most common source of funds for businesses around the world, are, perhaps, the commercial Banks.   But there are other institutions, apart from Banks, that also provide finance to busiesses on more liberal terms, albeit at higher rates of interest.   Factors are one such institution.

It is not always easy and convinient for a new business, or a yet to be established one to raise money from a Bank.   Generally, Banks have an elaborate system of evaluations and assessments of the financial requirements of various businesses, and their eligibility for the same.   Invariably, Banks require the borrower to provide some sort of collaterals for the loan sought by them.   This presents a major problem, especially to small businesses.

Factoring can provide the necessary finance to such businesses on flixible terms.   For instance, a Factor is more concerned about the Buyers’ credentials, rather than the Sellers’.   It is the Buyers’ track record of honoring their financial committments in time, that persuades a Factor to finance the Seller.   Thus the Seller gains from the standing and the creditworthiness of his client, the Buyer, rather than his own.

For the Factor, the advantage it enjoys over traditional financing institutions like Banks, is that, by law,  they are relieved of compliance of certain regulations applicable to the Banking industry.

4)  Good for Bottomline:  The Seller Company gains in many ways by engaging the services of a Factor to get its invoices realized.   Faster realization, is one obvious benefit.   That apart, the Seller is relieved of the burden of maintaining detailed accounts ledgers, elaborate documentation, follow up of the invoices, and other administrative and legal hassels related to receivables management.   The entire responsiblity is taken up by the Factor from start to finish.   Further in case of default by the Buyer, it is the Factor that initiates the necessary administrative and legal actions necessary for the recovery of his debts.

For the Factor, in spite of taking all the trouble of realizing the Seller’s invoices, and undertaking the risk of default, etc., it is still a viable proposition on account of the higher profits accruing to it.

These are some of the major advantages of the factoring business to the parties involved in it.

In the next article, we shall study the flip side of the factoring business, that is, the disadvantaes and the risks this business poses to those involved in it.

                                                                                       To be concluded.

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