Financing: Factoring-Part I

Introduction:  One of the major stumbling blocks faced by a buiness is the financing of it.   A business requires money for various activities and purposes.   For example, a manufacturing concern requires money for procuring the raw materials, and processing the same into the finished goods.   That apart, money is required to pay the wages of the workforce,  servicing of the plant and machinery, upkeep of the premises, marketing of the products, etc.   Every stage of operations of the business requires infusion of money to ensure smooth functioning and to achieve the business goals.

Over a period of time, different methods of financing business have evloved.   The type of financing required by a business depends upon the nature of its activities, and related issues.   For example the type of financing required by a manufacturer of Televisions is different from that required by a Software Development Company.

Factoring:  Factoring is a type of financing available to any business that engages in sale of goods and services through the medium of the Invoice.   Practically, every business engaged in selling ‘raises’ an invoice on its buyer or client.   An invoice is a commercial document that provides details of the product or service being supplied, the unit price of each item of sale, the delivery terms, taxes where applicable, any discounts given, other charges if any, etc.   It also stipulates the time within which the buyer must pay for the goods and services.   This commercial document(invoice) represents the account receivables of the firm.   That is, the money that the firm will receive upon supply of the goods and services mentioned therein, from the buyer.

Now the seller of the goods and services as above, has two options to realize the proceeds of his sale.   One, he can wait for the buyer to make the payment in the normal course against the delivery of the goods/services as per the contract terms.   Second, the seller can also approach a ‘Factor’ to encash the invoice immediately.   The Factor is the financier who advances money to the seller against his invoices, that represent the seller’s receivables, at a discounted rate, and collects the full value of the invoice from the buyer. 

To clarify further, factoring is the financing of accounts receivables of the seller at a discount, and realizing the full proceeds form the buyer, now the debtor.   The factor first pays the seller, the realizable value of the goods and services evidenced in the invoice at a discount, and then recovers the full value of the invoice from the debtor, the buyer.

In a transaction like this, the factor, who is parting with his money, has to make sure of getting it back, not from the seller, but from the buyer.   Therefore, the financial standing and the creditworthiness of the debtor is of primary imoratance to the factor, more than that of the seller.   If the debtor defaults on payments, then the factor has  to suffer a loss.   As such, the factor would satisfy himself with the solvency of the debtor before engaging with him in this transaction.

There is another kind of factoring arrangement, called with recourse factoring.   It is similar to the regular or without recourse factoring, except that, in the event of default by the debtor, the factor has recourse to the seller, who has to make good the loss suffered by the factor.   That is the factor can recover the money advanced to the seller from the seller himself, alongwith his charges, etc., in case of the buyer’s default.

As can be seen, the with recourse factoring transaction is safer and more favorable to the factor.   However, for the same reason, that it is safer, it is also less remunerative to the factor.   The revenues and profits accruing to a factor are in proportion to the risk he undertakes under the transaction.

In future articles, we shall study how a factoring transaction actually looks like, the relative advantages and disadvantages of this type of financing for a business etc.

                                                                                          To Be Concluded