Q:Sir, I recently read about The Regulation of Factor Bill (Assignment of Receivables), 2011. It would be helpful if you could explain what factoring is.
A: Sure. Factoring is one of the oldest methods of financing by way of selling the accounts receivable of a firm. There are certain financial institutions called factors which provide this type of financing. The invoice approved by the buyer is sent to the factor. The factor in turn makes the payment to the company (seller).
What does the factor gain?
The invoice payment is done on a discount which usually ranges from 0.35 to 4 per cent of the value of the invoice. Also the entire amount is not paid by the factor. Usually it makes a payment of 75 to 80% keeping the remaining amount as reserve. The reserve amount is paid back when the buyer actually pays the amount. Thus the factor earns commission for factoring.
Does this imply that through factoring, all the sales made by a company are like cash sales? What are the advantages of factoring to the company?
As the factor pays the amount of sales to the company, it is equivalent to having all cash sales. Also the risk of collection of receivable and bad debts may be transferred to the financial institution acting as the factor based on terms agreed upon. Other advantages of going for factoring is that it frees up large amounts of funds locked up as accounts receivables and this can be used to purchase more inventory and fund other short term projects that can accelerate growth. Factoring also relieves a company from the burden of maintaining receivable accounts, conducting credit assessments for customers and handling collection of receivables. The working capital management of the company becomes efficient and hence, reduces the cost which in turn improves the possibility of better profits.
This seems great. So the companies can transfer all its accounts receivables to the factor and be risk free right?
This is not the case always. Companies must take judicious decision when going for factoring mode of financing. If the debtor is credit worthy and has paid all the debts in time, the company will lose money in terms of factoring fees. There must be a trade-off between the present value of the earnings a firm gains from sales and the cost of utilising factoring as a means for financing. For example, businesses which result in slower repayment can be factored so that the company is not affected by cash deficit for other needs.
If factoring is utilised for sundry debtors alone, why financial institutions provide this type of financing?
Factoring can be used in place of bank loans for small and medium enterprises. Though factoring costs are higher than bank rates, small companies which cannot obtain bank loans easily can resort to this mode of financing. Also factoring financial institutions look for the credit worthiness of the buyers and not the companies resorting to factoring. This proves to be an advantage for SMEs. Factoring is utilised by firms which cannot borrow money from other sources.
So what is the “Regulation of Factor Bill” about?
The bill provides regulations for factoring business by RBI. All financial institutions providing factoring services should get approval from RBI before entering into this business. Also the mechanism of assignment of receivables to the factor and payment of consideration by the factor will be regulated. This will also enable the factors to obtain legal remedy and claim their rights on the invoices factored by them in a more efficient manner.