Apart from traditional bank borrowings there are few non-banking financing options such as housing finance, leasing and hire purchase. "Factoring" is also a non-banking financing scheme that aims to provide temporary cash flow problems and, or improve liquidity of a business enterprise. This innovative financial instrument and scheme has been developed as an alternative source of financing other than the traditional bank finances to support and speed up the money market within the economic and financial system. Through factoring, a business can raise fund by selling its "accounts receivable" at a discount without assuming new debt.
A business operating on open account credit terms may need to obtain immediate cash to purchase raw materials for optimising its production capacity which in turn increases turnover and profitability. The business may also need to have sufficient working capital to pay salaries to employees and meet day to day expenses and gain financial stability to accelerate business growth. Banks provide working capital loan subject to a favourable credit rating of the business and adequate collaterals. Factoring option allows the business to get working capital without any credit rating and collateral but the financial credentials of the client is important, because in order to qualify for factoring, the invoice should have a reasonable profit margin, and should be free from liens, legal disputes and tax problems. Moreover, the accounts receivable should represent a bonafide sales of goods or rendering of services and the factor needs to evaluate the customer's ability to pay the price of its purchase on due date.
Factoring covers wide range of commodity sectors and companies of all sizes, but the factor does not purchase all 'accounts receivable' of a business; it picks up only selected receivables that qualify for factoring in an effort to reduce the potential amount of bad debts.
Factoring is also a management aid for the professional management of accounts receivables of a business by a third party, the "factor". A factor is a third-party specialised financial intermediary that finances a business through a transaction known as "receivable purchases financing". For this purpose, a business can generate an "invoice" for sales to a factor, once the sold goods are delivered and the title has been transferred to the buyer. The seller can get the money by selling the invoice instead of waiting 30, 60 or 90 days for payment from the customer. The normal period of factoring is up to 90 days or even 120 days and rarely exceeds more than 150 days.
Factoring services offer a comprehensive receivables and payable management solution which include short term financing as well as management services for collection of commercial receivables. The factor typically charges interest on the advance plus a commission/service charge. The price paid for the receivables is discounted from the invoice value and discount/interest rate is applied similar to an interest rate associated with home loans, credit cards and car loans.
Demand for factoring comes from a business both from a financial perspective (getting immediate cash as working capital) and a management perspective (collection management of receivables). So, factoring is not directly comparable with traditional financial tools because of the existence of the management service components. As such, factoring is a package service of financing and management of accounts receivable.
Factoring includes three major parties: client, factor and customer. The client assigns invoice to the factor based on which the factor makes a pre-payment to the client, which is normally up to 80 per cent of the assigned price. The balance 20 per cent remains in reserve. The factor collects the accounts receivable from the customer as per the credit terms, and then returns reserve balance to the client minus a fee for the factoring service and assuming the collection risk. The factor's overall income is the difference between the price it paid for the invoice and the money received from the debtors, less the amount lost due to non-payment.
Basically, there are two factoring models: the common one is "advance factoring model", under which, the factor generally pays the client major portion of the face value of the invoice before the due date of the receivable. The other one is "maturity model", under which the factor collects the fund on maturity and then transfers it to the client. Advance factoring model is very popular in new business enterprises as well as in manufacturing industries because the improved cash flow allows them to do more business.
Factoring may be done for both domestic as well as international trade receivables. It may be disclosed as well as undisclosed. There are "recourse factorings'', where the client collects the money from the customer but in case the customer does not pay the amount on maturity then the client is responsible to pay the amount to the factor. There are also "non-recourse factorings", where the factor undertakes the risk to collect the debts from the customer and in case of non-recovery, the client remains out of any obligation to pay to the factor. Credit card is an example of non-recourse factoring, because the bank (factor) cannot claim the money from the seller; the bank can only claim the money from the card holder. In international business, "Cross border/export factoring" is done to finance an exporter against his foreign accounts receivables normally without recourse.
Factoring is not a loan; it is conversion of credit sales into cash. It is also not a rival to bank lending but contains a financial component which can be utilised as a compliment to bank loan. Using factoring is not a signal that the company has financial troubles or difficulties, rather it is a normal act of business management and in fact, it is a sign that the supplier company is "managerially" sound.
However, factoring discount rate can be a bit higher than normal bank interest rate because the cost includes financial cost (interest), management cost for collection of trade receivables (commission/service fee) and cost of collection risk. The suitability of factoring involves comparing company's traditional accounts receivable management and financial cost and factoring cost. In view of this, a cost benefit analysis for the factoring needs to be done to compare the cost and benefit associated with factoring.
Considering the cost factor, factoring is not recommended until more traditional forms of financing have been explored. It is also not recommended for long-term financing. It is most applicable to short-term financing and situations where a company is growing rapidly and has a large enough gross margin to support the high interest rates. Once the growth begins, the business then looks forward towards more traditional forms of financing.
Factoring has got momentum in America, Europe and developing countries like India. It may also experience a robust growth in Bangladesh, if the scope of factoring can be expanded against deferred payments. It may act as a catalyst to boost the present sluggish money market of Bangladesh and help the manufacturers and suppliers, particularly exporters, to improve the scope of their operating leverage. But in order to gain popularity, the factors have to establish their credibility in offering better management of receivables and financing at competitive rates to the clients. It is also necessary to update factoring related laws, rules and regulations in line with those in countries practising factoring.
The writer is Vice President, Institute of Cost and Management Accountants of Bangladesh (ICMAB). [email protected]
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