In the day to day business, firms are bound to ask for credit when they purchase and should give credit to its buyers when they sell. What if a large portion of sales of a firm is in credit and they don’t have sufficient funds to operate their business? This is exactly what happens with many firms. This problem gets severe in case of small firms, who often face shortage of working capital. When firms have a lot of receivable and they don’t have liquidity, they want to collect those receivables as early as possible. Here, Factoring comes to rescue.
Factoring is a continuous arrangement between a financial institution (known as the factor) and a business concern (known as the client) whereby the factor purchases the account receivable/trade debts of the client.
So there are three parties involved in factoring-
- Client- It is the company which sells goods/services on credit.
- Debtor- It is the customer who purchases goods from the client.
- Factor- It is the financial institution which acts on behalf of the client to collect debts from the debtor.
the client is immediately paid 75%-85% of the account receivable/trade debt by the factor and when the debtor repays their dues the factor will make the remaining 20% payment. In a layman’s language, a factor is an agent who collects debts of his client for a certain fee.
Along with the collection of dues, a factor also performs the following functions for his client-
- Sales Ledger management: once the factoring agreement is made, it is the duty of factor to maintain the sales ledger of the client. the factor has to perform functions like crediting the clients account when payment is received, sending statements to the customer, resolving disputes between the client and customer.
- Credit control and credit protection: the factor has to maintain extensive information records about the financial standing and credit rating of individual customers and their track record of payments, he is able to advise its client on whether to extend credit to a buyer or not.
- Provision of finance: when the factoring agreement is finalised the factor immediately pays 75%-85% of the trade debts to the client. this enables the client to ahead with his business and focus on production schedules without any interruption.
- Consultancy services: the factor also provides consultancy to the client about upcoming business opportunities, the changing business environment, financial profile of customers etc.
Factoring mechanism- The modus operandi of the factoring is as follows:
- Customer places orders with the client for goods/service on credit. Client delivers goods and sends invoice to the customer.
- The client assigns invoice to the factor.
- Factor makes payment up to 80% and sends periodic statements to client.
- Customer makes payment to factor
- Factor makes remaining 20% payment to client on realisation the from debtor.