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.

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.

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