Business Financial Factoring

A lot of working capital is tied up in the form of trade debts. Collection of debts, especially for the small scale and medium scale companies is the biggest problem. The average collection period has been on the increase. Delays in collection process in turn lead to liquidity problems and consequently to delay in production and supplies.

II. Modus Operandi:

A factor provides finance to his client up to a certain percentage of the unpaid invoices which represent the sale of goods or services to approved customers. The modus operandi of the factoring scheme is as follows:

• There should be a factoring arrangement between the client and the factor, which is the financing organization.

• Whenever the client sells goods to trade customers on credit, he prepares invoices in the usual way.

• The goods are sent to the buyers without raising a bill of exchange but accompanied by an invoice.

• The debt due by the purchaser to the client is assigned to the factor by advising the trade customers, to pay the amount due to the client, to the factor.

• The client hands over the invoices to the factor under cover of a schedule of offer along with the copies of invoices and receipted delivery challans.

• The factor makes an immediate payment up to 80% of the assigned invoices and the balance 20% will be paid on realization of the debt.

III. Terms and Conditions:

The existence of an agreement between the factor and the client is central to the function of factoring.

The main terms and conditions generally included in factoring agreement are the following:

a. Assignment of debt in favour of the factor.

b. Selling limits for the client

c. Conditions within which the factor will have recourse to the client in case of non-payment by the trade customer

d. Circumstances under which the factor will have recourse in case of non-payment.

e. Details regarding the payment to the factor for his services, say for instance, as a certain percentage on turnover.

f. Interest to be allowed to the factor on the account where credit has been sanctioned to the supplier, and

g. Limit of any overdraft facility and the rate of interest to be charged by the factor.

IV. Cost of Factoring:

The cost of factoring comprises of two aspects namely finance charges and service fees. Since the factor provides 80% of the invoice as credit, he levies finance charges. This charge is normally the same interest rates which are in vogue in the banking system. Factoring is a cheap source because the interest is charged only on the amount actually provided to the client as repayment of his supplies. Apart from this financial charge, a service charge is also levied. This service fees is charged in proportion to the gross value of the invoice factored based on sales volume, number of invoices work involved in collections. Generally, the factor charges a service fee on the total turnover of the bills. It is around 1%. If the bills get paid earlier service charges could be reduced depending upon the volume of work involved.

V. Pricing of Factoring Services:

While pricing factoring services, the following components should be taken into account.

a. Factoring fees or administrative charges.

b. Discount charges

Factoring fees This is charged mainly as administrative expenses for providing various services to the clients namely:

a. Sales ledger administration

b. Credit control administration

c. Bad debts administration

This fee is normally compared with reference to the projected sales turnover of the client during the next twelve months. It is always quoted as a percent of projected sales turnover. Generally, this charge varies between 1% and 2.5% of the projected turnover.

In fact, the quantum of levy actually depends on several factors as given below:

a. Reputation of the client as well as the debtors.

b. Nature of the industry to which the client belongs.

c. Volume of sales per annum.

d. Terms of sales.

e. Average invoice value

f. Security available to the factor

g. Type of factoring service offered

h. Profit margin.

Usually a minimum handling/administrative charge is stipulated to which a certain percent of the projected turnover is added.

Discount Charges For providing instant credit to the client by way of prepayment, some charges have to be levied and they are called discount charges. This charge is normally linked with the base rate.

Costing and pricing technique Generally, cost plus pricing strategy is adopted for fixing the price for factoring services. Therefore factoring charge = cost + profit.

While arriving at the cost, one should take into account the fixed cost which remains fixed irrespective of volume of business and the variable cost which varies directly with the volume of business transacted.

Again, the pricing strategy depends on the costing technique that is being adopted, either absorption costing or marginal costing. Absorption costing is based on the principle that the client would be required to pay for the entire fixed cost as well as the variable cost while in the case of marginal costing; the entire variable cost and a part of fixed cost only would be recovered.

Accounting system Generally, a factoring company keeps the following accounts to record the factoring transactions:

a. Sales ledger control account It contains the main asset account of various debtors of clients. It is nothing but the clients debtors accounts.

b. Debt purchase account It is a replica account of sales ledger control account. In other words, it is a copy account of sales ledger control account and hence the sales ledger control account and debt purchased account would depict the same balance at a given period. It is also called master control account.

c. Client current account It is nothing but a statement of account of a client showing all debits and credits.

d. Bank account It is used to record all cash received from debtors of clients and cash paid to the client.

Sales ledger control account and debt purchased account must be maintained separately for each customer.