Finance: Factoring-Part II

In an earlier article, we had studied the definition of Factoring.  In this article, we shall examine how a factoring transaction takes place practically.

Example:  M/s.Omega Foods is an upcoming  manufacturer of processed health foods for humans, based in Connecticut.   The Company’s products are gaining in popularity through the United States.   In the last year(2008), the Company had recorded sales of USD: 2.02 million.   The Omega range of health foods is widely available in the U.S., from the local Mom and Pop stores to some of the larger  Supermarkets.

M/s.Omega Foods distributes their merchandise in U.S.A. through a network of 65 distributors and dealers.   Further, they afford 35 days credit to them, on their bills drawn on these distributors and dealers, that is their buyers.

M/s.Omega Foods has an arrangement with Alpha Factors, a Company engaged in the business of Factoring, to avail of this facility to the extent of USD: 0.50 million at a time.   Under this arrangement, Alpha Factors advances money to Omega Foods, against their invoices drawn on their buyers.  

Let us assume that Omega Foods have made a sale of USD:0.25 million to M/s.Super Stores.   As per arrangement, Omega Foods notifies their buyer Super Stores of the factoring arrangement it has with Alpha Factors, and forwards a set of commercial documents including the invoice to Super Stores.   Simultaneously, it forwards another set of the documents to Alpha Factors.   Omega Foods have given 35 days credit to Super Stores to make good the payment for the merchandise supplied by them.

Alpha Factors scrutinize the documents submitted by Omega Foods, and finding them in order, remit USD:244,000.00 to Omega, as against the invoce value of USD:194,000.00.   Of the difference amount of USD:56,000.00, USD:50,000.00 represents the reserve amount retained by the Factor against possible payment default by the buyer,  USD:5,000.00 represents the discount at which the Factor has advanced money to the seller, and USD:1,000.00 represents the interest charged by the Factor for the 35 days that it will be out of funds, till the buyer reimburses it.

Let us assume that Super Stores have honored their committment under the factoring arrangement, and have remitted the amount of the invoice i.e. USD:250,000.00 to the Factor, within the stipulated time of 35 days.   Thereupon the Factor would release the reserve amount of USD:50,000.00 to the seller.   This would complete the transaction.

However, not all factoring transactions end happily.   Sometimes the debtor may default in paying the Factor and putting the Factor to financial risk/loss.   In the above example, let us assume that the buyer, Super Stores have defaulted and failed to pay the Factor in time.   The Factor, would, then have to either recover the money from Super Stores, or write it off eventually, as a bad debt.   The Factor does not have remedy against the seller, Omega Foods, unless the contract provides for a with recourse to seller provision.

In the with recourse to seller factoring contract, the Factor has the right to recover from the Seller, the amount defaulted in by the Buyer, that was advanced to the Seller (by the Factor).   In this example, if Super Stores were to default upon payment to the Factor, then Alpha Factors would have recourse to Omega Foods, and recover the same from them.   Usually this is done by submission of another invoice by the Seller to the Factor, who adjusts the outstanding from the earlier transaction, by advancing money against the new invoice.   Of course, the Seller has the choice to reimburse the Factor, with his own money.  

An important point to note in a with recourse to seller factoring transaction, the Factor would not get the same level of returns as in the without recourse factoring transaction, because of the elimination of risk in the latter case.   Another way out for the Factor is to obtain insurance against the Buyer’s default.

In future articles, we shall study the risks and prospects of factoring business to those involved in it.

                                                                                       To be concluded.