The word factor is derived from the Latin word ‘facere’. It means to make or do or to get things done. Factoring simply refers to selling the receivables by a firm to another party. The buyer of the receivables is called the factor. Thus factoring refers to the agreement in which the receivables are sold by a firm (client) to the factor (financial intermediary). The factor can be a commercial bank or a finance company.
When receivables are factored, the factor takes possession of the receivables and generally becomes responsible for its collection. It also undertakes the administration of credit i.e. credit control, sales accounting etc. Thus factoring may be defined as selling the receivables of a firm at a discount to a financial organisation (factor). The cash from the sale of the receivables provides finance to the selling company (client). Out of the difference between the face value of the receivables and what the factor pays the selling company (i.e. discount), it meets its expenses (collection, accounting etc.). The balance is the profit of the factor for the factoring services.
Objectives of Factoring
Factoring is a method of converting receivables into cash. There are certain objectives of factoring. The important objectives are as follows:
- To relieve from the trouble of collecting receivables so as to concentrate on sales and other major areas of business.
- To minimize the risk of bad debts arising on account of non-realisation of credit sales.
- To adopt better credit control policy.
- To carry on business smoothly and not to rely on external sources to meet working capital requirements.
- To get information about the market, customers’ creditworthiness etc. so as to make necessary changes in the marketing policies or strategies.
Process of Factoring (Factoring Mechanism)
The firm (client) having book debts enters into an agreement with a factoring agency/institution. The client delivers all orders and invoices and the invoice copy (arising from the credit sales) to the factor. The factor pays around 80% of the invoice value (depends on the price of factoring agreement), as advance. The balance amount is paid when the factor collects the complete amount of money due from customers (client’s debtors). Against all these services, the factor charges some amounts as service charges. In certain cases the client sells its receivables at discount, say, 10%. This means the factor collects the full amount of receivables and pays 90% (in this case) of the receivables to the client. From the discount (10%), the factor meets its expenses and losses. The balance is the profit or service charge of the factor. Thus there are three parties to the factoring. They are the buyers of the goods (client’s debtors), the seller of the goods (client firm i.e. seller of receivables) and the factor. Factoring is a financial intermediary between the buyer and the seller.
There are six types of factoring: Recourse Factoring, Non-Recourse Factoring, Maturity Factoring, Advance Factoring, Invoice Discounting, and Undisclosed Factoring.