Basic concepts of factoring along with case study

1. FACTORING
MERCHANT BANKING

2. WHAT IS FACTORING?
Factoring is a financial transaction
whereby a business sells its accounts
receivable (i.e., invoices) to a third party
(called a factor) at a discount in exchange
for immediate money with which to
finance continued business

3. PROCESS
OF
FACTORING

4. a) Client concludes a credit sale with a customer.
b) Client sells the customer’s account to the Factor and notifies the
customer.
c) Factor makes part payment (advance) against account purchased, after
adjusting for commission and interest on the advance.
d) Factor maintains the customer’s account and follows up for payment.
e) Customer remits the amount due to the Factor.
f) Factor makes the final payment to the Client when the account is
collected or on the guaranteed payment date.
PROCESS INVOLVED IN FACTORING

5. DIFFERENCE BETWEEN FACTORING AND A
BANK LOAN
•First, the emphasis is on the value of the
receivables (essentially a financial asset), not the
firm’s credit worthiness.
•Secondly, factoring is not a loan – it is the purchase
of a financial asset (the receivable).
•Finally, a bank loan involves two parties whereas
factoring involves three.

7. FACTORING CONCEPT
• In factoring, a financial institution (factor) buys the
accounts receivable of a company (Client) and pays up
to 80%(rarely up to 90%) of the amount immediately on
agreement.
• Factoring company pays the remaining amount
(Balance 20%-finance cost-operating cost) to the client
when the customer pays the debt.
• Collection of debt from the customer is done either by
the factor or the client depending upon the type of
factoring.

8. TYPES OF FACTORING
 D O M E S T I C FA C TO R I N G
 I N T E R N AT I O N A L FA C TO R I N G
 R E C O U R S E FA C TO R I N G
 N O N R E C O U R S E FA C TO R I N G
 M AT U R I T Y FA C TO R I N G
 I N VO I C E FA C TO R I N G

9. Domestic Factoring
The factoring arrangement where all the three- the factor, the seller and the
buyer are in the same country, subject to the same laws.
International Factoring
The factoring arrangement, where the seller and the buyer are in two
different countries involving co-operation between two factoring companies, one in
the seller’s country (Export Factor) and the other in the buyer’s country (Import
Factor). Generally it is based on non recourse factoring
Invoice Discounting
In this type of factoring arrangement, only finance is provided and no other
service is offered.

10. Recourse Factoring
In this type of factoring arrangement, the factor provides all types
of facilities except debt protection. In other words, the client is
responsible for any bad debts incurred
 Upto 75% to 85% of the Invoice Receivable is factored.
 Interest is charged from the date of advance to the date of collection.
 Factor purchases Receivables on the condition that loss arising on
account of non-recovery will be borne by the Client.
 Credit Risk is with the Client.
 Factor does not participate in the credit sanction process.
 In India, factoring is done with recourse.

11. Non-Recourse Factoring
It gives protection against bad debts to the client. In other
words, in case the customer fails to pay, the factor will have ‘no
recourse’ to
the client and will have to absorb the bad debts himself.
Factor purchases Receivables on the condition that the Factor has no
recourse to the Client, if the debt turns out to be non-recoverable.
Credit risk is with the Factor.
Higher commission is charged.
Factor participates in credit sanction process and approves credit limit
given by the Client to the Customer.
In USA/UK, factoring is commonly done without recourse.

12. Maturity factor
Factor does not make any advance payment to the Client.
Pays on guaranteed payment date or on collection of Receivables.
Guaranteed payment date is usually fixed taking into account previous collection
experience of the Client.
Nominal Commission is charged.
No risk to Factor.
Disclose factoring
The debtor is informed of the assignment of debts and debtor directly pays
the money to the factor
Undisclosed factoring
The debtor is not informed of the agreement entered into between the seller
and the factor. Most of the cases disclose factoring is happen in UK

13. FACTORING CHARGES
Finance Charge - It represents the interest on funds
made available to the client by way of prepayment
against purchase of approved invoices.
Service Charge - The charge levied for rendering non-
funding services such as collection, sales ledger
maintenance and other advisory services.
One time setup fee

14. WHY USE FACTORING?
• Through the use of Factoring receivables are instantly converted into
cash leading to improved cash flows that can help funding of future
growth.
• It facilitate an efficient follow up of payments from buyers, which is
made possible through relationships developed by factors with client’s
buyers.
• Factoring provides credit protection for export sales which enables to do
business with buyers who are unwilling to open Letters of Credit.
• Factoring also provides other peripheral services such as advisory
services, credit assessment, etc.
• Factoring is used by a firm when the available Cash Balance held by the
firm is insufficient to meet current obligations and accommodate its
other cash needs, such as new orders or contracts

15. FACTORING IS NOT SUITABLE UNDER
FOLLOWING CASES
a) where large volume of cash sales take place.
b) engaged in speculative business.
c) selling highly specialized capital equipment's or made-to-order
goods.
d) where credit period offered to the buyers is more than 180 days.
e) where sales are to the sister / associated companies
f) where sales are to the public at large, etc.

16. BENEFITS OF FACTORING
•The client will be relieved of the work relating to
sales ledger administration and debt collection
•The client can therefore concentrate more on
planning production and sales.
•The charges paid to a factor which will be
marginally high at 1 to 1.5% than the bank charges
will be more than compensated by reductions in
administrative expenditure.
•This will also improve the current ratio of the client
and consequently his credit rating.

17. CASE
STUDY

18. ABC Aviation Inc., a fictional reseller of aviation parts, has focused on
international sales and was recently awarded contracts by companies in
Guatemala and Peru. Two of these contracts were small, totalling $250,000 in
sales, and were due in one month. The third contract, however, was valued at
$500,000 – a substantial amount for ABC Aviation. The parts for this contract
were due in two months. The following table outlines the orders:
Contract COGS Sale
revenue
Delivery Date Terms
1 $55,000 $100,000 Next month Net 45
2 $82,500 $1,50,000 Next month Net 45
3 $3,00,000 $5,00,000 2 months Net 45
The company has $150,000 in the bank – enough to cover the Cost of Goods Sold
(COGS) for the first two contracts, but not enough to cover the third contract.
The only way that ABC Aviation can fulfil these contracts is to use financing.

19. Working with the Export Import Bank:
Ex-Im Bank’s export credit insurance was critical for the
success of the transaction. The company managed to get
the foreign clients approved, which covered up to 80% of
the receivable face value in case of default.
This coverage limited the risk to the point that the
transaction could be financed using factoring.

20. Step 1: Deliver contracts 1 & 2
Before export factoring-
Contracts Cash Bank A/R Payroll General Expenses
2 $1,50,000 $2,50,000 $10,000 $1,37,000
Cash surplus $2500
Step 2: Use export factoring on first two invoices
After export factoring-
Contracts Cash (bank) A/R Reserve Payroll General Expenses
2 $3,50,000 $0 $50,000 $10,000 $1,37,500
Cash surplus $2,02,500

21. Step 3: Deploy purchase order finance
Immediately after PO fund
Contract Cash (bank) A/R Reserve Payroll General
expense
All 3 $3,50,000 $5,00,000 $50,000 $10,000 $4,37,500
Cash surplus $3,02,500
Step 4: Factor the invoice for the last contract
After Export Factoring
Contracts Cash (bank) A/R Reserve Payroll General
expenses
All 3 $7,50,000 $0 $1,50,000 $10,000 $4,37,500
Cash surplus $3,02,500

22. What if a foreign client does not pay?
Account debtor default is an inherent risk in
international transactions, where collections can be
difficult. However, this risk was greatly minimized
by using the Export-Import Bank’s credit insurance
program.

23. Thank you