Factoring is a financial transaction between two parties, client and a factor, in which the client sells its accounts receivable (Money owed to client by a buyer) to the factor to receive money immediately in exchange.
Factoring is an agreement in which receivables arising out of a sale of goods/services are sold by a firm (client) to the factor (financial intermediary) as a result of which the title of goods/services represented by the receivables passes on to the factor.
It is an arrangement between a factor and his client which includes any two of the following services provided by the factor to the client –
- Maintenance of account
- Collection of debts
- Protection against credit risk
Through factoring an organization (client) relieves itself from the procedures and expenses of collecting receivables arising out of a sale and receives immediate cash to finance its business operations.
A factoring agreement involves three parties:
The Factor, The Client (sells receivables to factor), Customer (pays to factor)
Functions of a Factor:
- Maintaining Accounts – Preparing and updating sales ledger and providing periodic reports with useful information
- Providing advisory services – Advices the client regarding credit worthiness of a buyer, potential customers, market trends etc.
- Providing Short-term Finance – Provide money in advance up to 80% of the receivables
- Providing Credit Protection – Protects the client against bad-debts/non-payment
- Providing Collection Facilities – Collect money on behalf of the client and remits the money back after deducting his charges
Mechanism of Factoring
A Factoring contact for sale of receivables –
• It starts with a credit sale and agreement between the client and the buyer/customer.
• The client (seller)
- Sells goods on credit to buyer/customer
- Prepares invoice, delivery challan, factoring agreement and other documents
- Hands over the documents to factor (Financial institution/Banking Institution)
- Receives payment in advance up to 80% of cost of good by the factor
• The factor
- Makes an advance payment to factor on receiving all the documents (invoice, challan, agreement etc.)
- Prepares and sends periodical account statements to customer
- Receives payment from customer/buyer on due date
- Remits the balance (20%) from the money collected to the client/seller after deducting its commission, fees, service charges etc.
Advantages of Factoring:
To Client/Seller –
- The client gets immediate cash on sale which can be invested somewhere else.
- It protects the client against credit risk i.e. risk of non-payment by buyer.
- It allows the client to offer lucrative credit schemes to customers and increase his sales and profit.
- It reduces the financial burden of the client and relieves him maintaining accounts and collection of receivables
- It acts as an additional source of finance for the client and allows him to explore new markets.
To Customers/Buyers –
- It allows customers to save bank charges and expenses.
- It allows customers to purchase expensive products through flexible credit schemes.
- The factoring procedure is simple and easy than applying for a bank loan, it saves time, money and effort.