BUSINESS STUDIES (CLASS 11) WORKSHEET 15-FACTORING

EMERGING MODES OF BUSINESS IN INDIA 

Factoring

Factoring is a type of finance in which a business would sell its accounts receivable (invoices) to a third party to meet its short-term liquidity needs. Under the transaction between both parties, the factor would pay the amount due on the invoices minus its commission or fees.
Essentially factoring transfers the ownership of accounts to another party that then chases up the debt. Factoring therefore relieves the first party of a debt for less than the total amount providing them with working capital to continue trading, while the buyer, or factor, chases up the debt for the full amount and profits when it is paid. The factor is required to pay additional fees, typically a small percentage, once the debt has been settled. The factor may also offer a discount to the indebted party.

Factoring is a very common method used by exporters to help accelerate their cash flow. The process enables the exporter to draw up to 80% of the sales invoice’s value at the point of delivery of the goods and when the sales invoice is raised.

1. Debt purchase facility entered into between exporter and financier
2. Financier provides debt protection.
3. Notice of assignment of debt (invoice) to financier provided to importer.
4. Goods shipped and the exporter gives invoice to importer.
5. Financier purchases invoice and pays 80% proceeds to exporter
6. Importer pays the invoice to financier and exporter receives balance.

Advantages and disadvantages of factoring

There are a number of advantages to factoring but it is also worthwhile to consider any potential drawbacks.

Advantages of factoring
1. Factoring provides a quick boost to cashflow. This may be very valuable for businesses that are short of working capital.
2. There are many factoring companies, so prices are usually competitive.
3. It can be a cost-effective way of outsourcing your sales ledger while freeing up your time to manage the business.
4. It assists smoother cashflow and financial planning.
5. Some customers may respect factors and pay more quickly.
6. Factors may give you useful information about the credit standing of your customers and they can help you to negotiate better terms with your suppliers.
7. Factors can prove an excellent strategic - as well as financial - resource when planning business growth.
8. You will be protected from bad debts if you choose non-recourse factoring.
9. Cash is released as soon as orders are invoiced and is available for capital investment and funding of your next orders.
10. Factors will credit check your customers and can help your business trade with better quality customers.

Disadvantages of factoring
Queries and disputes may have a negative impact on your available funding. For this reason, factoring works best when a business is efficient and there are few disputes and queries.
Other disadvantages:
1. The cost will mean a reduction in your profit margin on each order or service fulfilment.
2. It may reduce the scope for other borrowing - book debts will not be available as security.
3. Factors will restrict funding against poor quality debtors or poor debtor spread, so you will need to manage these funding fluctuations.
4. To end an arrangement with a factor you will have to pay off any money they have advanced you on invoices if the customer has not paid them yet. This may require some business planning.
5. Some customers may prefer to deal directly with you.
6. How the factor deals with your customers will affect what your customers think of you. Make sure you use a reputable company that will not damage your reputation.