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Receivables factoring or debtor financing, is when a company buys a debt or invoice from another company. Factoring is also seen as a form of invoice discounting in many markets and is very similar but just within a different context. In this purchase, accounts receivable are discounted in order to allow the buyer to make a profit upon the settlement of the debt. 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.
Factoring is not the same as invoice discounting (which is called an assignment of accounts receivable in American accounting – as propagated by FASB within GAAP). Factoring is the sale of receivables, whereas invoice discounting (“assignment of accounts receivable” in American accounting) is a borrowing that involves the use of the accounts receivable assets as collateral for the loan. However, in some other markets, such as the UK, invoice discounting is considered to be a form of factoring, involving the “assignment of receivables”, that is included in official factoring statistics. It is therefore also not considered to be borrowing in the UK. In the UK the arrangement is usually confidential in that the debtor is not notified of the assignment of the receivable and the seller of the receivable collects the debt on behalf of the factor. In the UK, the main difference between factoring and invoice discounting is confidentiality. Scottish law differs from that of the rest of the UK, in that notification to the account debtor is required for the assignment to take place. The Scottish Law Commission is [when?] reviewing this position and seeks to propose reform by the end of 2017.
Process of Factoring
The factoring process can be broken up into two parts: the initial account setup and ongoing funding. Setting up a factoring account typically takes one to two weeks and involves submitting an application, a list of clients, an accounts receivable aging report and a sample invoice. The approval process involves detailed underwriting, during which time the factoring company can ask for additional documents, such as documents of incorporation, financials, and banks statements. If approved, the business will be set up with a maximum credit line from which they can draw. In the case of notification factoring, the arrangement is not confidential and approval is contingent upon successful notification; a process by which factoring companies send the business’s client or account debtor a Notice of Assignment. The Notice of Assignment serves to
Once the account is set up, the business is ready to start funding invoices. Invoices are still approved on an individual basis, but most invoices can be funded in a business day or two, as long as they meet the factor’s criteria. Receivables are funded in two parts. The first part is the “advance” and covers 80% to 85% of the invoice value. This is deposited directly to the business’s bank account. The remaining 15% to 20% is rebated, less the factoring fees, as soon as the invoice is paid in full to the factoring company.
Types of Factoring
Recourse factoring means the credit risk of the customers of the business is assumed by the business only and not by the factor. Essentially, in this type of factoring the factor is only a financing and collecting agent for the business. Commission charges would have been higher if the factor would also have assumed the credit risk. Here, the charges would only include a component of interest on the money advanced and service charge for collecting the money.
Under this type of factoring, unlike recourse factoring, the factor assumes the risk of customer credit. In a case of default by the customer, the business is not liable to pay anything. Off course, higher commission charges are charged to the business for this additional service.
Advance factoring implies the payment of money in advance. As soon as the invoice is taken under factoring, the invoice amount less commission and the margin are paid to the business. The margin is paid post realization of the money from the customers. This margin ranges anywhere between 5% to 25%.
There are factoring services which offer the benefit of collection mainly. Maturity factoring is that kind of factoring where the invoice amount is paid after the realization from the customer. The job of a factor is to collect the money from the customer. Here, the charges of factoring would also be less as the component of interest would be dropped.
Bank Participation Factoring
This is a special arrangement whereby the margin of a factor is also financed by the bank. This is most suitable for the business for who even the small margin of money is important. This kind of factoring arrangement allows the business to have complete finance of the account receivables and needs almost no money to conduct business.
It is the most popular form of factoring where the factor provides the client with all types of facilities like protection from bad debt, collection, etc.
Domestic And Cross-Border Factoring
Factor giving the services of purchase, management, funding and collection of accounts receivable in domestic territory is termed as domestic factoring. Here three parties are involved i.e. buyer, seller, and factor who are located in the same country. Whereas, if the same services are provided in international markets then it is termed as cross-border factoring. Here four parties are involved i.e. exporter, importer, export factor and import factor.
Suppliers Guarantee Factoring
This is another very innovative way getting out of difficult business situations. In this type of factoring, the role of factor involves taking guarantee of the business. The factor guarantees the payment of the suppliers of the business and on the other side takes factors the invoices of the business. Once the money is realized from the invoices, the factor first makes payment to the suppliers of the business and then the remain portion of the business after cutting necessary fee for the same.
Disclosed And Undisclosed Factoring
Disclosed factoring means the customer of the business is aware of the factoring arraignment of the business. On the contrary, in undisclosed factoring, the customer does not know about the factoring arrangement. The entrepreneur puts a stamp on the business indicating the payment to be made to the factor in place of the staff of the business.
The following are the functions performed by a factor:
Maintenance Of Sales Ledger
A factor is responsible for maintaining the sales ledger of the client. So all the sales transactions of the client are taken care of by the factor.
The factor finances the client by purchasing all the account receivables.
In the case of non-recourse factoring, the risk of non-payment or bad debts is on the factor.
Collection of Money
The factor performs the duty of collecting funds from the client’s debtors. This enables the client to focus on core areas of business instead of putting energies in the collection of money.