Introduction : Receivables constitute a significant portion of current assets of a firm. But, for investment in receivables, a firm has to incur certain costs such as costs of financing receivables and costs of collection from receivables. Further, there is a risk of bad debts also. It is, therefore, very essential to have a proper control and management of receivables. In fact, maintaining of receivables poses two types of problems; (i) the problem of raising funds to finance the receivables, and (it) the problems relating to collection, delays and defaults of the receivables. A small firm’ may handle the problem of receivables management of its own, but it may not be possible for a large firm to do so efficiently as it may be exposed to the risk of more and more bad debts. In such a case, a firm may avail the services of specialised institutions engaged in receivables management, called factoring firms.
Meaning and Definition : Factoring may broadly be defined as the relationship, created by an agreement, between the seller of goods/services and a financial institution called .the factor, whereby the later purchases the receivables of the former and also controls and administers the receivables of the former. Factoring may also be defined as a continuous relationship between financial institution (the factor) and a business concern selling goods and/or providing service (the client) to a trade customer on an open account basis, whereby the factor purchases the client’s book debts (account receivables) with or without recourse to the client - thereby controlling the credit extended to the customer and also undertaking to administer the sales ledgers relevant to the transaction. The term” factoring” has been defined in various countries in different ways due to non-availability of any uniform codified law. The study group appointed by International Institute for the Unification of Private Law (UNIDROIT), Rome during 1988 recommended, in simple words, the definition of factoring as under: “Factoring means an arrangement between a factor and his client which includes at least two of the following services to be provided by the factor: · Finance · Maintenance of accounts · Collection of debts · Protection against credit risks”. The above definition, however, applies only to factoring in relation to supply of goods and services in respect of the following: i. To trade or professional debtors ii. Across national boundaries iii. When notice of assignment has been given to the debtors. The development of factoring concept in various developed countries of the world has led to some consensus towards defining the term. Factoring can broadly be defined as an arrangement in which receivables arising out of sale of goods/ services are sold to the “factor” as a result of which the title to the goods/services represented by the said receivables passes on to the factor. Hence the factor becomes responsible for all credit control, sales accounting and debt collection from the buyer (s).
Mechanism of Factoring : Factoring business is generated by credit sales in the normal course business. The main function of factor is realisation of sales. Once the transaction takes place, the role of factor step in to realise the sales/collect receivables. Thus, factor act as a intermediary between the seller and till and sometimes along with the seller’s bank together. The mechanism of factoring is summed up as below: i. An agreement is entered into between the selling firm and the firm. The agreement provides the basis and the scope understanding reached between the two for rendering factor service. ii. The sales documents should contain the instructions to make payment directly to the factor who is assigned the job of collection of receivables. iii. When the payment is received by the factor, the account of the firm is credited by the factor after deducting its fees, charges, interest etc. as agreed. iv. The factor may provide advance finance to the selling firm conditions of the agreement so require. Parties to the Factoring There are basically three parties involved in a factoring transaction. 1. The buyer of the goods. 2. The seller of the goods 3. The factor i.e. financial institution. The three parties interact with each other during the purchase/ sale of goods. The possible procedure that may be followed is summarised below.
1. The buyer enters into an agreement with the seller and negotiates the terms and conditions for the purchase of goods on credit.
2. He takes the delivery of goods along with the invoice bill and instructions from the seller to make payment to the factor on due date.
3. Buyer will make the payment to the factor in time or ask for extension of time. In case of default in payment on due date, he faces legal action at the hands of factor.
1. The seller enters into contract for the sale of goods on credit as per the purchase order sent by the buyer stating various terms and conditions.
2. Sells goods to the buyer as per the contract.
3. Sends copies of invoice, delivery challan along with the goods to the buyer and gives instructions to the buyer to make payment on due date.
4. The seller sells the receivables received from the buyer to a factor and receives 80% or more payment in advance.
5. The seller receives the balance payment from the factor after paying the service charges.
1. The factor enters into an agreement with the seller for rendering factor services i.e. collection of receivables/debts.
2. The factor pays 80% or more of the amount of receivables copies of sale documents.
3. The factor receives payments from the buyer on due dates and pays the balance money to the seller after deducting the service charges.
Benefits of Factoring:
A firm that enters into factoring agreement is benefited in a number of ways as it is relieved from the problem of collection management and it can concentrate on other important business activities.
Some of the important benefits are outlined as under:
(a) It ensures a definite pattern of cash inflows from the credit sales.
(b) It serves as a source of short-term finance.
(c) It ensures better management of receivables as factor firm is a specialised agency for the same.
(d) It enables the selling firms to transfer the risk of non-payments, defaults or bad debts to the factoring firms in case of non-recourse factoring.
(e) It relieves the selling firms from the burden of credit management and enables them to concentrate on other important business activities.
(f) It saves in cost as well as space as it is a substitute for in-house collection department.
(g) In provides better opportunities for working capital management.
(h) The selling firm is also benefited by advisory services rendered by a factor.
Limitations of Factoring:
In spite of May services offered by factoring, it suffers from certain limitations.
The most critical fall outs of factoring include:
(i) The high cost of factoring as compared to other sources of short-term finance,
(ii) The perception of financial weakness about the firm availing factoring services, and
(iii) adverse impact of tough stance taken by factor, against a defaulting buyer, upon the borrower resulting into reduced future sales.
(JEMTEC, School of Law)