Factoring – Introduction, Advantages and Disadvantages
Factoring is a service of financial nature involving the conversion of credit bills into cash. Accounts receivables, bills recoverable and other credit dues resulting from credit sales appear, in the books of accounts as book credits. Here the risk of credit, risk of credit worthiness of the debtor and as number of incidental and consequential risks are involved. These risks are taken by the factor which purchase these credit receivables without recourse and collects them when due. These balance-sheet items are replaced by cash received from the factoring agent. Factoring is also called “Invoice Agent” or purchase and discount of all “receivables”.
Advantages of Factoring: Factoring provides various benefits to the clients, banks and customers. We shall discuss the benefits of factoring hereunder:
The following are the advantages of factoring service to the clients:
1. The client or seller can convert accounts receivables into cash without bothering about sales ledger administration even repayment in some cases.
2. Factoring ensures a definite pattern of cash inflows.
3. Continuous Factoring virtually eliminates the need for the credit department. That is why receivable financing through Factoring is gaining popularity as useful source of financing short term fund requirements of business enterprises because of the inherent advantage of flexibility it affords to the borrowing firm. The seller firm may continue to get finance on its receivables on a more or less automatic basis. If its sales expand or contract, it can vary the financing proportionately.
4. Unlike an unsecured loan, compensating balances are not required in this case. Another advantage consists of relieving the borrowing firm of substantial credit and collection costs and further to certain extent from a considerable part of cash management.
5. In export sales, difficulties of credit assessment and debt collection are more pronounced. Availing of Professional factoring services is more advantageous.
6. Under factoring arrangement, regular cash inflow at periodical intervals is assured. This helps, short term fund flow and availing of discounts from suppliers.
7. Firms engaged in a highly seasonal business may submit the peak loan of receivables to the Factor for credit review and approval as a cheaper alternative to expanding its own credit department.
8. Finally, when credit is necessary and cannot be obtained elsewhere either because of tight money conditions or poor financial position, the Factoring of receivables will be more appropriate.
The following are the advantages of Factoring service to the customers:
1. The customer is relieved of maintaining record relating to credit sales customers a/c, reminders to debtors, initiating recovery measures, etc. This saves substantial administration expenditure.
2. Factoring as a professional approach in collection of debts inculcates discipline in cash management among customers.
3. Buyers have no need to accept any bill.
4. Buyers will have adequate credit period for payment.
5. Factoring will facilitate credit purchases.
6. Saving on bank charges and expenses.
7. No documentation problems; only a simple undertaking agreeing to make payment directly to factor is required.
8. Factor furnishes periodical statement of outstanding invoices drawn on the buyers.
The following are the advantages of Factoring service to the banks:
1. Factoring provides the banks an integrated receivables management.
2. Factoring improves the service efficiency of the banks through closer follow up of credit sales.
3. Factoring provides increasing cash flow and liquidity to the banks.
4. Factoring improves the quality of the advances made by the banks by reducing the turnover of receivables and by increasing operating cycles.
5. Factoring enhances the profits through cash discounts on purchase.
6. Factoring safeguards as insurance against non-performing assets of the banks. In this, all proceeds of factored bills are credited to bank; hence bank account will not become non-performing assets for shortage of credits.
It may possibly result in over dependence on Factoring, mismanagement, over trading or even dishonesty on the client's part.
The cost of financing being higher than the normal lending rate, Factoring is an expensive way of financing.