Factoring – An Integral Cog in the Supply Chain
Factoring is the process of outright sales of a company’s receivables to a third party known as the factor.
Factoring transfers the rights and ownership of the asset (receivables) to the factor along with all associated cash flows. The amount paid by the factor is adjusted for a discount factor compared to the value of the receivables. This discount accounts for the time value of money (interest cost between the time of sale and the time the money is realized), processing fee, bad debt provisions, etc. Forfaiting is a similar product to factoring but differs in the fact that it usually involves the sale of a receivable which has been created due to export transactions. Often times, there is a trade instrument involved, like a Letter of Credit, which changes the risk perspective somewhat.
Factoring vs. Invoice Discounting
It is necessary to distinguish factoring from invoice discounting. Whereas factoring involves an outright sale of invoices, invoice discounting is essentially a loan against accepted invoices and would actually be treated as a loan with recourse to the seller. This difference is what makes factoring more desirable to sellers and is also, therefore, slightly pricier as compared to invoice discounting.
When to use Factoring
Factoring of receivables may be required if a company is facing a cash flow shortage. The overall cost of factoring would depend on various factors, like the prevailing interest rates, processing fee, and crucially – the factor’s credit appetite on the debtor (the company who has to pay the invoice). In case the debtor is a top rated company, the seller can get a good rate to sell an invoice accepted by such a company.
In a cross country trade, factoring could be a good way for a seller to mitigate it’s credit risk on counterparties, especially in the early days when they have less information about the local markets. This would also allow them to tap a factor’s own network or their correspondent network for local expertise.
Benefits of a factoring arrangement
Factoring benefits a seller in the following ways:
- The seller gets without-recourse financing against the invoices (although with-recourse factoring is also insisted upon by banks under certain conditions)
- The seller gets credit protection in case a default by the buyer, as the loss is absorbed by the factor
- The factor offers collection services for payment from buyers. This gives the factor greater control over account receivables and saves the seller collection costs.
- Administrative ease as reconciliation is more efficient
- Better buyer credit management for the seller
- Access to a factor’s network across geographies
- Some factors provide value-added services like local expertise in certain markets, market intelligence on sellers, introduction to potential business partners and so on
- The seller can better manage their balance sheet
- Factoring would allow sellers to offer more favorable terms to their buyers and thus expand their business
Factoring provides a seller the ability to gain from the relationship between a debtor and a factoring agency (especially if it’s the debtor’s banking partner). In such a situation, the seller would get quick and relatively cheap funding by a Balance Sheet friendly method to improve its cash position.